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.

In the last couple of months, there has been widespread media coverage (including several prior posts on The D & O Diary) discussing the growing investigation into options backdating. New allegations have surfaced that may evidence options “springloading.”

Options backdating involves retroactively dating the grant and exercise price of an options issue to a time preceding a rally in the price of the underlying shares, which maximizes the profits for the grant recipients. Options springloading, according to this June 7, 2006 Reuters article, involves looking forward to set the grant date and exercise price ahead of the release of positive news expected to raise share values, also boosting option profits.

Analog Devices Inc.’s November 15, 2005 tentative settlement with the SEC regarding the company’s stock option practices involve allegations of practices that, although not using the term “options springloading,” present the circumstances that phrase describes. The company’s announcement stated that the settlement addressed

ADI’s disclosure regarding grants of options to employees and directors prior to the release of favorable financial results….The SEC settlement would conclude that ADI should have made disclosures in its proxy filings to the effect that ADI priced these stock options prior to releasing favorable financial results.

Under the settlement Analog Devices agreed to pay a civil money penalty of $3 million, and certain of the grants to officers and directors were repriced.

Options springloading may be involved in the circumstances described in a June 9, 2006 New York Times article about options practices at Cyberonics. According to the article, the company’s Board approved stock option grants for top executives one evening in June 2004, a few hours after the company received positive news about the regulatory prospects for a promising product. When trading began the next day, Cyberonics share price soared, along with the value of the options. The option grant gave the Company’s chairman and CEO instant paper profits of $2.3 million, and lesser amounts of paper profits for the other two executives who received options in the grant. The company has publicly challenged the notion that there was anything wrong with the grant, saying that the options grant was immediately reported, and noting that none of the grant recipients has yet exercised any of options. The securities analyst whose recent report first questioned the Cyberonics option grant noted that while the grant did not involve options backdating, “the effect is exactly the same.” The analyst also noted that options are supposed to align executives’ financial interests with those of investors, but because these options were granted before investors were able to trade on the good news, the grant operated as a reward rather than an incentive. He also contends that because the options were priced below the market value fully loaded for the good news that was known to the company when the grant was made, the grant should have been counted as compensation in the quarter in which the grant was made.

The Reuters article cited above also contained a report that the SEC is looking at whether auditors have culpability in connection with the options backdating investigation. According to the article, the SEC is looking into whether auditors knew about the questionable practices and whether the auditors may have signed off on improper options backdating and springloading.

Article Plug: The D & O Diary recommends the recent law review article by Sean Fitzpatrick appearing in the Fordham Law Review. This article, entitled “The Small Laws: Eliot Spitzer and the Way to Insurance Market Reform,” argues that while Eliot Spitzer’s campaign against contingent commissions purportedly sought to eliminate anticompetitive behavior in the insurance brokerage industry, the ironic effect of Spitzer’s efforts is that smaller brokers may be harmed, as a result of which there may be further consolidation in the insurance broker industry, resulting in less rather than more competition. The article’s author recommends simpler, less draconian solutions for reform. The article may be found here.

Vonage Holdings Corp.’s May 24, 2006 IPO raised hundreds of millions of dollars of capital. It has also generated extensive negative press, as exemplified by the June 3, 2006 front-page article (subscription required) in the Wall Street Journal entitled “How Vonage’s IPO Stumbled.” To add injury to insult, the company, several of its directors and officers, and its offering underwriters have been sued in a purported securities class action lawsuit filed in United States District Court in New Jersey. The lawsuit was filed on June 2, 2006, only ten days after Vonage’s debut (which undoubtedly is the shortest interval between IPO and lawsuit since the Refco fiasco). The lawsuit (and indeed much of the adverse publicity) is focused on the somewhat unique Directed Share Program by which Vonage pre-sold 13.5 million of the offering shares to its own customers. The Complaint accuses the defendants of a number of errors or violations in connection with the Directed Share Program.

There are several interesting things about the Vonage IPO lawsuit. The first is that the lead law firm is not one of the usual plaintiff’s class action securities firms, but is the Motley Rice firm, best known for its prominence in asbestos and tobacco litigation. Perhaps the Milberg Weiss firm’s woes are encouraging opportunistic competition. Indeed, another law firm on the Complaint, Kahn Gauthier Swick, is also best known for its attorneys’ prior involvement with tobacco litigation, and was the subject of a prior D & O Diary post for the firm’s activities in connection with options backdating investigations.

Another interesting thing about the Vonage IPO securities lawsuit is that even though the Complaint’s grievances center on the alleged malfunctioning of the Directed Share Program, the purported class on whose behalf the lawsuit supposedly is brought is not limited just to the Vonage Customers who participated in the Directed Share Program, but purports to include all investors who purchased shares in the offering. The implication seems to be that all IPO investors feel the pain from the alleged Customers’ Directed Share Program malfunction.

The third and most interesting thing about the Vonage IPO Securities lawsuit is its reliance on the defendants’ alleged violation of NASD Rule 2310, the so-called “suitability” rule. The rule requires anyone recommending a security to “have reasonable grounds for believing that the recommendation is suitable” for the customer based on the customer’s “other security holdings…financial situation and need.” The Company defendants are alleged to have violated Rule 2310 because they supposedly allowed (encouraged) its customers to purchase shares regardless of suitability. This alleged violation is stretched to the Offering Underwriters, because they allegedly were responsible for ensuring that Vonage complied with NASD Rule 2310.

While the seasoned tort lawyers who filed the Vonage securities lawsuit score points for creativity in their foray into the securities arena, their overall theory (at least to the extent it relies on NASD Rule 2310) strikes The D & O Diary as ultimately deficient on several grounds. Even if the defendants violated NASD Rule 2310, the aggrieved persons’ remedies are under the NASD Rules themselves (presumably, some form of arbitration or even some kind of NASD disciplinary action), not an action for damages under the securities laws. There is no separate private right of action for damages under the securities laws for NASD Rules violations, and there is to the knowledge of The D & O Diary no authority to support the notion that NASD Rule 2310 has been incorporated as a substantive standard under the federal securities laws, violation of which gives rise to a claim for damages.

The ultimate deficiency with the plaintiffs’ attempt to bootstrap an alleged violation of NASD Rule 2310 into a damages claim under the federal securities laws is that, even if there were a violation of NASD Rule 2310, the alleged violation is still missing the indispensable element to support a securities action. That is, what the securities laws protect against is misrepresentations or omissions. A violation of NASD Rule 2310, while arguably grievous, does not establish the existence of a misrepresentation or omission.

Setting aside the merits of the lawsuit, there are the merits of the IPO itself to be taken into account. The risk factors in Vonage’s Prospectus make for some interesting reading. Not only has the company consistently incurred losses since its inception (with an accumulated deficit through March 31, 2006 of $467.4 million), but its service prices “are lower than those of many competitors for comparable services,” and the Company anticipates that “prices will continue to decrease.” Most interestingly, the Company’s founder, Chairman and “Chief Strategist,” is Jeffrey A. Citron, whose prior association with Datek Online resulted in his paying $22.5 million in civil penalties, “among the largest fines ever collected by the SEC against individuals,” according to Vonage’s Prospectus.

So cue the whimsical Vonage jingle tune, and just recall what Vonage itself says in its ads about the kinds of things people do.

Marginal Note: An alert D & O Diary reader points out that in February 2006, Motley Rice opened an Atlanta office and started a securities litigation practice by luring four securities class action attorneys from the Chitwood Harley Harnes firm. Chitwood Harley Harnes promptly sued the four lawyers and their new firm.

FLSA "Explosion": The June 5, 2006 issue of the Wall Street Journal has an article (subscription required) commenting on the "explosion" in cases under the Fair Labor Standards Act (FLSA). The article also contains statistics showing the number of FLSA actions increased four-fold between 2000 and 2005. EPL insurers have been struggling to find the appropriate marketplace response to this increased risk. The National Underwriter recently carried an article (subscription required) describing wage-hour claims as "the next frontier" for employment practices liability insurance (EPL) carriers. To date, the extent of available coverage for this type of claim seems to be restricted to sublimited defense cost coverage, available from only a few carriers.

Enron Trial Redux: In case you missed it over the weekend, the June 4, 2006 issue of the New York Times carried a lengthy article detailing the prosecutor’s development of the legal strategy used in the criminal trial against Kenneth Lay. The Times article has generated much commentary, not all of it flattering to the prosecutors. Perhaps most notable are the comments of Professor Larry Ribstein in his Ideoblog post discussing the Times article. Among other things, Professor Ribstein comments:

Many people no doubt will get a warm feeling from the job our government servants have done in finally nailing the evil Lay. But as I said at the beginning, there’s an alternative narrative. The prosecutors were out to get Lay, who had already been convicted by public opinion just for being associated so closely with Enron, which of course journalists, filmmakers and other shapers of public opinion had already elevated into the symbol of whatever it was that went pop at the end of the big boom.

The WSJ.com lawblog also has a commentary on the Times article and Professor Ribstein’s post. The WSJ.com lawblog post has attracted some interesting responses, which are reproduced following the WSJ.com lawblog post.

Class Action Internet Sites: Lies, Damned Lies and Forward Looking Statements, the blog written by plaintiffs’ lawyer Adam Savett, has a very useful post. that contains links to separate case-specific Internet resources devoted to the major securities class action cases, including the Enron, WorldCom and IPO Laddering cases, among others. Find the post here.

Fannie Mae Settlement: The CorporateCounsel.net blog has a thoughtful June 5, 2006 post with perceptive commentary on the "Lessons on the Fannie Mae Settlement." The author’s comments contain some interesting observations about corporate governance and board functioning. Find the post here.

Category: Tales from the Fringe, Subcategory: "Oogabooga": For those of you who have always wondered what the legal consequences would be from the inadvertent inclusion of the word "oogabooga" in an Australian tribunal’s ruling on a Burmese refugee’s asylum application (I am not making this up), you will want to look here. We will have to wait for another day to find out the consequences of the intentional use of the word "oogabooga."

 

Now that we have the criminal verdicts in the Enron criminal trial, it may be time to check in on one of the key legal reforms to arise from the Enron scandal. Among the key provisions that Congress included in the Sarbanes-Oxley Act was the so-called whistleblower provision, a tribute to the role of whistleblower Sherron Watkins in the Enron scandal. Section 806 of the Sarbanes-Oxley Act was included to encourage employees to blow the whistle on corporate wrongdoing by shielding them from retaliation. The law applies to all publicly traded companies and carries both civil and criminal remedies.

When the Department of Labor Occupational Safety Health Administration released the regulations implementing Section 806, some commentators speculated that the whistleblower laws and regulations “may well have as much effect on business practices, in the twenty-first century, as did civil rights laws in the twentieth.” But three years’ experience under the laws suggest that the reality — at least so far — is falling short of these predctions.

According to a recent Washington Post article, of the approximately 750 whistleblower complaints filed so far, the vast majority have been dismissed. Only five whistleblowers have won, though the number fell to four when one case was reversed on appeal. Three of the other four cases remain on appeal.

But while these statistics might suggest that the potential threat from whistleblower cases was overblown, there are other considerations that suggest that the potential danger from whistleblower cases should continue to be taken very seriously. First, of the roughly 750 cases filed so far, approximately 100 cases have been settled. Second, the rate of filing has increased each year since the law’s enactment. Only about 150 cases were filed in the first year, but more than double that number were filed in the most recent year. Since many cases were filed only recently, the number of settlements is a significant statistic.

The most significant suggestion that whistleblower cases remain a serious corporate risk is the development in a recent case, where an employee’s claim was permitted to proceed even though there was no accounting fraud involved. In a March 29, 2006 decision, the tribunal filed in favor of a fired employee of Nova Information Systems (a subsidiary of US Bancorp). The employee claimed she had been retaliated against for complaining that the financial institution’s security controls were inadequate, increasing the risk of identity theft. Her employer argued, among other things, that no statutory violation occured because the alleged disclosure did not involve an allegation of fraud against shareholders. According to the Post article, the tribunal ruled that it was sufficient to survive a dismissal motion for the complaintant to allege that she provided information of a violation of an SEC rule or regulation, regardless whether the violation related to shareholder fraud. (The tribunal has not yet made a final decision on whether the employee was illegally fired.)

A similar issue is involved in a closely watched case pending before a US District Court in North Carolina. A former employee of Wyeth Pharmaceuticals (who has exhausted administrative procedures) alleges that he was fired in retaliation for raising concerns that vaccine production employees were improperly trained, in violation of FDA regulations. Wyeth argues that the allegations, even if true, are not sufficient to state a whistleblower claim because only disclosure of accounting fraud is protected against retaliation. A lengthy discussion of the Wyeth Pharmaceuticals whistleblower case may be found here.

A broad reading of the whistleblower protection could represent a significant concern to employers. If employees may claim that a job action arose in retaliation for an employee’s supposed complaint about a violation of any rule or regulation (that is, not just disclosure of accounting fraud, and not even just disclosure of a violation of an SEC rule, but disclosure of a violation of an FDA rule or any other federal rule or regulation, which would pretty much encompass an entire universe of possibilities), whistleblower complaints could indeed become the threat that early commentators feared. Potential consequences include not only the whistleblower’s make-whole civil remedy under the statute (including attorneys’ fees), but in serious cases the threat of an investigation by a regulatory agency, adverse publicity, and even criminal sanctions.

The Enron criminal case may have gone to the jury, but the ramifcations from the scandal continue to unfold. The whistleblower statute may yet prove to be one of the more important permanent legacies of the Enron scandal. A good overview of the case law “so far” — including a discussion of the numerous issues that remain unresolved — can be found here.

An interesting commentary on Sherron Watkins, questioning the bona fides of her whistleblowing credentials, can be found here.

On May 30, 2006, American Tower Corporation became the fourth company to be named in a securities class action lawsuit connected with the options backdating probe. (As noted in this prior post on The D & O Diary, the three companies previously named in securities class action lawsuits related to options backdating are Vitesse Semiconductor, Comverse Technology, and United Health Group.) American Tower also reported that it had been named in a shareholders’ derivative lawsuit in Massachusetts state court.

In an even more ominous development on the options backdating litigation front, on May 30, 2006, the plaintiffs’ firm of Kahn Gauthier Swick LLC issued a press release announcing "the creation of the nation’s first privately funded Independent Options Pricing Investigations Division," which reportedly was formed to invesitgate options backdating at U.S. companies. The press release names five companies the firm is currently investigating (Altera Corp., Brocade Communications, Broadcom Corp., Brooks Automation and CNet Networks), and urges shareholders of these companies to contact the firm "to discuss your legal rights." According to Kahn Gauthier’s website, the firm was founded by tobacco litigation plaintiffs’ attorney Wendall Gauthier.

Thompson Memo Update: In a prior post, the D & O Diary commented on the enormous burden the so-called Thompson Memo places on business organizations facing criminal investigations. Among other things, the firms can find themselves forced to withhold payment of their individual employees’ attorneys’ fees, or even to waive the attorney client privilege, in a bid for leniency in a criminal prosecution. The May 31, 2006 issue of USA Today carries a lengthy story discussing these issues in greater detail. Accompanying the article is a spiffy chart listing the 21 companies that have been forced to waive their attorney client privilege in connection with criminal investigations. The chart lists the wide variety of types of criminal matters in which the issue has arisen. According the WSJ.com law blog, the government’s decision to indict the Milberg Weiss law firm has drawn together a variety of different organizations who object to the prosecutorial action of forcing firms to waive the privilege or cut off employees’ attorneys’ fees or face the death penalty of corporate criminal indictment. Among the groups joining together to voice their concern are the US Chamber of Commerce, corporate counsel groups and corporate defense lawyers.

Coming Soon to a Courtroom Near You?: You may have missed it over the long holiday weekend, but on Saturday, May 27, 2006, the Wall Street Journal carried an article (subscription required) entitled "Scandals Seem Bad Now? Just Wait," speculating on the corporate scandals to come now that the grandaddy of them all from the last wave of corporate scandals — the Enron criminal prosecution — has been to the jury. The article conjectures that the credit boom of the last few years will generate several waves of scandals, including issues arising from: "proprietary trading at investment banks"; "scandalously incompetent lending" — the prediction is that future blow ups will "expose those in the hedge fund world and elsewhere who’ve taken on excessive risk in pursuit of quick returns"; securitized loans, such as collateralized debt obligations, which the article comments is "an area rich in conflicts of interests, hazy pricing, excessive leverage and opportunities for self-dealing." Other fruitful areas for "tomorrow’s accounting outrages" include excessive executive compensation, hedge funds’ excessive management fees, and dual-share stock structures that enable founders or insiders to maintain corporate control to the detriment of other shareholders.

 

Individual Settlement Contributions: When the Enron and WorldCom consolidated class action settlements were announced, much was made of the fact that individual directors and officers were compelled to contribute to those settlements out of their own assets without recourse to insurance or indemnity. This occasioned debate about whether the requirement for individuals’ settlement contribution represented a trend or was simply an attibute of the massive fraud involved in those particular corporate scandals. The debate continues, but it has been little noted that there was at least one significant subsequent settlement that also included this feature of individuals’ contributions out of their own funds without indemnity or insurance.

On January 12, 2006, Tenet Healthcare announced the settlement of the consolidated securities class action lawsuits and shareholders’ derivative lititgation that had been filed against the company and six present or former directors and officers, among other defendants. The company said that the monetary settlement would consist of a payment of $215 million by the company and/or its D & O insurers. In addition, two individual defendants agreed to contribute an additional $1.5 million to the settlement out of their own funds — Jeffrey Barbakow, Tenet’s former chairman and chief executive agreed to contribute $1 million, and Thomas Mackey, Tenet’s former chief operating officer, agreed to contribute $500,000. According to the Notice of Proposed Settlement sent to the class members regarding the settlement, “the sums contributed by [Barbakow and Mackey] shall not be reimbursed to them, by their insurance carriers or by Tenet or its agents.” A Wall Street Journal article discussing this settlement, including the individuals’ contributions, may be found here (via wsj.com, subscription required).

First-Ever Patriot Act Enforcement Action: On May 22, 2006, the SEC announced its first-ever enforcement action under the Patriot Act. The enforcement action was brought against broker-dealer Crowell, Weedon & Co. under the anti-money laundering provisions of the Patriot Act that requires broker-dealers to implement and document identity verification procedures for all new accounts. The SEC alleged that Crowell, Weedon’s representatives were simply filing attestations that they had personal knowledge of each of then new account holders, rather than following the brokerage’s specified procedure to search public databases and review government issued identification documents. Crowell, Weedon did not admit to violations but agreed to enter a cease and desist order.

While the enforcement action against Crowell, Weedon relied exclusively on the specific Patriot Act provisions relating to broker-dealers, the Act’s anti-money laundering provisions generally apply to a very broad range of financial institutions and authorizes a broad range of sanctions for failure to comply with those provisions. Among other things, regulatory agencies are authorized to consider a financial insitution’s record of combating money laundering when reviewing applications in connection with a merger or acquisition, and financial institutions are subject to civil and criminal penalties of up $1 million for money laundering violations. The SEC may have pursued Crowell, Weedon to make an example, but it is far likelier that the SEC, energized by Congress’s March 2006 renewal of the Patriot Act, is newly motivated to add some enforcement teeth to the Act’s money laundering provisions. The D & O Diary expects to see more Patriot Act enforecement actions against a broader range of financial institutions.

Options Backdating and D & O Insurance: As The D & O Diary noted in its May 11, 2006 post, the plaintiffs’ class action lawyers have quick to try to capitalize on the growing options backdating scandal and have launched a number of securities class action lawsuits against companies caught up in the probe. This development is obviously of concern to directors and officers liability insurance carriers, and the May 24, 2006 issue of Business Insurance has an article entitled “Stock Option Probe Sparks D & O Concerns” (subscription required) discussing the possible impact of the options backdating story on the D & O insurance marketplace.

Talleyrand on Options Backdating: As the options backdating story has continued to unfold, some have questioned whether or not there is anything wrong with options backdating. For example, the wsj.com law blog has a May 23, 2006 video post containing a debate between a business school prof and a CNBC reporter on the topic. Options backdating is obviously not harmless — the revelation of options backdating has already proven damaging to at least some of the companies caught up in the probe as they have had to restate their past financials to reflect their true compensation costs. But even beyond the restatement threat, there is a particular reason why the options backdating story has gained momentum in a way that stories about excecutives’ use of corporate aircraft or gold-plated pensions have not. The peculiar feature of the options backdating scandal is captured in the following epigramatic statement of Talleyrand:

If a gentleman commits follies, if he keeps mistresses, if he treats his wife badly, even if he is guilty of serious injustices toward his friends, he will be blamed, no doubt, but if he is rich, powerful and intelligent, society will still treat him with indulgence. But if that man cheats at cards he will be immediately banished from decent society and never forgiven.

The whole point of options-based compensation is to align executives’ financial interests with those of investors. Options-based compensation should subject executives to the same investment risk as investors. But back-dating options to ensure that executives gain in a way that investors cannot not only breaks the alignment between executives’ interests and those of investors, it unfairly stacks the deck in the executives’ favor. It is, in Talleyrand’s memorable phrase, cheating at cards, which no one will ever forgive. The D & O Diary believes the options backdating story has legs and has a long way to run.

For more about Talleyrand and Options backdating, see this post.

Thompson Memo Redux: Due to a technological snafu, subscribers to The D & O Diary did not receive an email feed for my May 23, 2006 post commenting on the Thompson memo. (Since the syndication service is free, I am hardly in a position to complain.)

The so-called “Thompson Memo,” is an internal Department of Justice memorandum specifying the circumstances under which business organizations will be criminally prosecuted. The document places a great deal of emphasis on an organization’s level of cooperation in the prosecutor’s decision whether or not to prosecute the firm. The memo’s onerous cooperation standards have been the highly criticized, most recently in the editorial (via wsj.com, subscription required) in the May 22, 2006 issue of the Wall Street Journal. The Journal condemns the government’s decision to prosecute the Milberg Weiss law firm, saying the government “essentially held a gun to Milberg Weiss’s head and threatened to indict unless the firm waived the attorney-client privilege and agreed to label its own partners criminals.” The editorial asserts (with an ironic acknowledgement of the fact that it is downright odd for the Journal to be defending Milberg Weiss) that this is “a dangerous precedent that can — and surely will– be used against more honest business enterprises.”

Just as insidious as government attempts to compel business organizations to waive the attorney-client privilege is the attempt to force companies to cut off their employees’ attorneys fees. There is an extensive debate whether or not the government improperly pressured KPMG — in connection with the allegations that KPMG sold fraudulent tax shelters — to withhold individual employees’ and partners’ defense fees. (KPMG itself, seeking to avoid the death sentence of a criminal indictment, agreed to a $456 million deferred prosecution agreement). A May 19, 2006 post of the Corporate Crime Reporter attibutes the following to the Judge who heard argument in a pretrial hearing in the KPMG matter:

Isn’t it just perfectly obvious from a reading of the Thompson memorandum that it is the position of the United States Department of Justice that a company facing possible prosecution hurts its case for a favorable outcome by advancing defense costs to present and former employees, except where they are legally obligated to do so, and that the natural consequence of that is that some corporations in that position, in furtherance of their enlightened self-interest, will cut off defense costs for individuals, who in the fullness of time will be indicted, and thus be deprived to one degree or another of the means of mounting a defense against the indictment?

Other cases have presented this same question. In March 2006, a federal judge granted a three-month postponement of the criminal trial of five former executives of Enterasys Networks. According to defense lawyers’ filings, government lawyers pressured the company to cut off legal fees to the defendants to weaken the employees’ ability to fight the charges. A March 28, 2006 Wall Street Journal article (via wsj.com, subscription required) discussing the Enterasys Networks case also states that in their investigation of accounting fraud at HealthSouth, federal prosecutors informed the company that payment of fees to indicted executives would be viewed as a sign of noncooperation, according to defense lawyers. The article also reports that prosecutors encouraged Symbol Technologies to withhold fees from exectives charged in an alleged accounting fraud. (Symbol apparently was able to pay the fees after it convinced prosecutors that the company bylaws required it to do so.) An article in the Spring 2006 issue of The John Liner Review (subscription required) details the government’s largely successful efforts in connection with the prosecution of two executives from Westar Energy to prevent the utility from advancing defense costs to the officers despite the company’s bylaws clearly mandating advancement

An extensive April 17, 2006 New York Times article discussing the issue of individuals’ attorneys’ fees and corporate cooperation under the Thompson Memo can be found here. (Registration required.)

The cover page of the Thompson memo states that “[f]urther experience with these guidelines may lead to additional adjustments.” The time for the additional adjustments is overdue.

Update: The options backdating story has grown beyond The D & O Diary’s ability to keep up with it. Fortunately, wsj.com has set up a separate page devoted to options backdating, which it updating on a daily basis. The WSJ Law Blog has an interesting post examining the apparent turf battle between the EDNY and the SDNY in issuing subpoenas in the options backdating probe (current score: EDNY 7 subpoenas, SDNY 6).

On May 12, 2006, the United States District Court for the Southern District of New York preliminarily approved the settlement of the consolidated derivative litigation filed on behalf of AOL Time Warner against 25 of the company’s present and former directors and officers as well as other third party defendants. The various derivative lawsuits alledged that the defendants had breached their fiduciary duties in connection with the AOL/Time Warner merger. The settlement requires the company to undertake a wide variety of corporate governance reforms. A cursory reading of the settlement documents might also lead one to conclude that the settlement also involved a payment of $200 mm by the company’s directors and officers insurance carriers in settlement of the derivative litigation, which would make this settlement by far the largest derivative settlement of which The D & O Diary is aware. However, a closer reading of the settlement documents reveals a more nuanced picture about the monetary portion of the settlement.

The Stipulation of Settlement filed with the Court states that on September 5, 2005, the derivative litigation plaintiffs made a policy limits demand under the Company’s D & O Policy, and on September 7, 2005, “the Company was able to reach a settlement with its directors and officers insurance carriers pursuant to which the carriers will pay approximately $200 million in addional fund in connection with the securities and derivative claims listed in Exhibit D.” Although the propinquity of the plaintiffs’ demand and the insurers’ settlment could be interpreted to suggest that the former caused the latter, that interpretation may be an illustration of the logical fallacy post hoc ergo propter hoc (“after this, therefore because of this”). By its own terms, the Stipulation states that the $200 mm payment under the insurance company settlement was in connection with both the derivative and the securities cases, not the derivative cases alone. Moreover, the referenced Exhibit D identifies 38 separate items of litigation in connection with which the insurance settlement had been made, including the SEC investigation, the DOJ investigation, the consolidated securities litigation, the ERISA litigation, and a very long list of many other items, including but definitely not limited to the derivative litigation.

Accordingly, it does not appear accurate to conclude that the $200 mm was paid just to settle the derivative litigation, or at least to settle the derivative litigation alone. Indeed, the parties never make that statement in any of the supporting documents. The documents state only that the “Derivative Actions were a substantial factor in the Company’s ability to obtain an approximately $200 million insurance recovery.” The settlement documents apparently are quite careful not to say how substantial of a factor the derivative actions were, or how substantial other factors (such as the $2.65 billion consolidated class action settlement) might have been.

The final settlement hearing in the consolidated derivative litigation is scheduled for June 28, 2006.