The following guest post by Jay W. Eisenhofer, Roy Jones, and Gregg S. Levin, all of Grant & Eisenhofer, P.A., first appeared in the March 19, 2007 issue of Pensions Week.

For those of us whose job it is to help maintain and enhance capital market integrity, the last few months have been quite interesting. In November 2006, the Committee on Capital Markets Regulation (“CCMR”), a business led group, issued a report suggesting that the U.S. suffers from the “over-enforcement” of the country’s securities laws. In January 2007, McKinsey & Company (“McKinsey”) published a study positing that the American “legal environment” was responsible for “growing international concerns about participating in US financial markets.” Picking up on this same theme, Peter Montagnon of the Association of British Insurers wrote in the Financial Times (5 January 2007) that an “excessive zeal for regulation and litigation” has undermined the ability of the U.S. capital markets to compete. What these reports have in common is an overriding bias and a lack of factual analysis. Tellingly, several non-partisan reports on the same subject have reached the exact opposite conclusion.

We will leave it up to others, better qualified, to comment on the CCMR report. Richard Breeden, former SEC Chair, no less, stated that the interim report “is a bunch of warmed over, impracticable ideas, many of which have been around for a long-time. It is very elegant whining.” Eliot Spitzer, no stranger to confronting fraud in corporate America, opined: “the same old tired response from the defenders of the status quo.” Meanwhile, the Council of Institutional Investors reflected that “many of the panel’s recommendations, if adopted, would undermine the effectiveness of market watchdogs and weaken critical investor protections.. . . Rigorous U.S. investor protections are a boon, not a bust, for our capital markets.” And presciently, Duke University Law Professor, James D. Cox, adroitly commented that the proposals are “an escalation of the culture war against regulation,” which if adopted “would be a dark day for investors.”

Critics use the following “fact” to support their IPO thesis -- of the 25 largest IPOs (by dollar volume) that took place during 2005, 92% (or 23 of 25) listed on an exchange outside of the U.S. But, this ignores the fact that current IPO activity on the American securities’ exchanges is indeed robust. Last year, U.S. IPO volume was up 22% over 2005, and almost 170% over 2003. A recent Thomson Financial (“Thomson”) report concluded: that during 2006, initial public offerings involving foreign firms comprised 16% of the IPOs placed on the American capital markets – the highest level of such offerings over the last 20 years; that the number of foreign IPOs being placed on the American capital markets remained the same in 2006 relative to the prior year (34); and that that during 2006, foreign IPOs were responsible for 23% of all new capital raised on the U.S. exchanges -- the highest figure in well over a decade. Commenting on these results, Richard Peterson, Thomson’s Director of Capital Markets Research, stated that “[i]n terms of proceeds raised by foreign issuers and the number of deals by foreign issuers, the statistics show that things look rather healthy . . . there doesn't seem to be any really significant deterioration of the [U.S.] IPO market.”

Critics wholly ignore that any volatility in recent U.S. IPO activity can be explained by factors unrelated to the current securities litigation system, including: high American underwriting fees; and expanding economies elsewhere in the world. For example, underwriting fees for U.S. based IPO transactions commonly run from 6.5% to 7%, as against an average 3-4% for deals placed on European exchanges. Goldman Sachs recently found that America's share of global gross domestic product has fallen to 28% -- from 31% seven years ago, as other country’s shares have grown. Reflecting that Ernst & Young recently found that since 2006 the overwhelming majority of firms undertaking IPOs (90%) did so in their “home country.”, yet 65% of “competitive” IPO’s held during the first half of 2006 were placed in the U.S. These findings prompted Jim O'Neill, Head of Global Economic Research at Goldman Sachs, to opine that “[i]t seems to me that the New York intelligentsia are going through one of their occasional bouts of hysteria” and further that any so-called decline in the American capital markets “is probably in large part a simple reflection of the growth of the rest of the world.”

Apart from the foregoing, critics overlook the fact that companies that list in the U.S. enjoy a lower cost of capital (12.48% on average), and also enjoy a listing premium of about 16%, rising to 37% for firms that list on a major U.S. exchange. Interestingly, research confirms that the listing premium actually has grown larger since the enactment of the Sarbanes Oxley Act in 2002. These statistics hardly suggest a system that is in terminal decline, and we would argue that investor protection through litigation is a key determinant.

Rarely discussed is the quality of IPOs. As investors are finding, the granting of a U.K. capital market passport to foreign companies is not costless. Financial fraud there. increased by 40% in 2006, and many worry that this will only get worse, as ever more overseas companies with dubious backgrounds and governance systems list there. Regulatory arbitrage may give a short-term competitive advantage, but it will come back to haunt the U.K. authorities; and sadly cost investors dearly.

According to Mr. Montagnon, liabilities from securities law class-action lawsuits have “ballooned” since 1995, bringing negative side effects. From that, Mr. Montagnon concludes that the securities class action system ought to be “repair[ed].” Once again context is essential. The size of the frauds themselves have ballooned since 1995, while their numbers have increased. Add to that, they are now more complex, and involve a broader range of actors. Reflecting that, the median investor loss for cases settling in 2006 reached $402 million – more than six times the 1996 median of $66 million. As regards settlements, 2006 brought six out of the ten largest settlements ever, with four of over $1 billion. Turning to the averages, both the mean and median settlement size have increased, again reflecting the size of the investor losses. Stripping out the mega-settlements still leaves an average settlement in 2006 of $34 million, a 37% increase over 2005. Including the billion dollar and over settlements pushes the average up to almost $87 million. As regards median settlement figures, 2006 saw a rise to $7.3 million.

Quite pointedly, after reviewing the data on settlements through the end of 2006, NERA Economic Consulting concluded that “while average settlements have been rising, there is no statistical evidence that this is the result of a more difficult litigation environment for defendants.”

Critics always disregard the dramatic changes that have taken place in our industry since the passage of the 1995 Private Securities Litigation Reform Act. Chief among these has been the rising number of institutional investors as class leaders, who take control of the litigation and use it to achieve positive, long-lasting governance reforms.

Many recent advances in shareholder rights and corporate governance have stemmed from this. The Delaware Supreme Court’s seminal decision in Smith v. Van Gorkom resulted in a host of procedural protections that we now take for granted such as fairness opinions, special committees of independent directors, and independent legal advisors. The Disney shareholder litigation over the payment of $140 million to Michael Ovitz heralded in a number of changes to corporate practices over the setting of executive compensation. In the wake of the WorldCom case, underwriters have been prompted to exercise a greater degree of care during the due diligence process. The superficial review that constituted due diligence before WorldCom apparently has now given way to real critical assessments of management’s representations.

Meanwhile, some critics assert that shareholder litigation is just shareholders suing themselves, since they are the actual owners of the defendant companies. In practice, shareholder suits reallocate funds to injured shareholder purchasers from current shareholders, as the former paid substantially more for a share of the corporation due to the fraud than did the current holders. Some overlap is inevitable here since institutional investors largely own all of corporate America. However, there are countless cases in which the overlap between “injured” and “current” shareholders is quite small. For example, in securities litigation involving Dynegy (settlement of $473 million), shareholders holding 127.23 million shares in the firm at the end the end of the class period (but not at settlement) owned only 5.49 million shares a year later.

Critics also fail to appreciate that private investor lawsuits are invaluable in ensuring that this country’s securities laws are vigorously enforced. Former SEC Chairman Arthur Levitt has stated that “private suits are the primary method for compensating defrauded investors.” The U.S. Supreme Court consistently has underscored that private actions “provide a most effective weapon in the enforcement of the securities laws and are a necessary supplement to Commission action.” This has never been more true than at present. While the number of enforcement actions commenced by the SEC is falling, corporate malfeasance is increasing. Financial restatements rose considerably during 2005, and over 100 companies currently are embroiled in the options-backdating scandal, just as questions are raised whether the SEC has adequate resources to investigate and prosecute these cases. Moreover, where corporate malfeasance has been the subject of both a private securities fraud class action and a parallel SEC investigation, the private action typically has resulted in a greater recovery for investors, with countless examples where the SEC’s efforts failed to achieve any financial compensation for aggrieved stockholders.

We share Peter Montagnon’s desire to see the U.S. initiate a system of corporate governance that makes corporate executives truly accountable to shareholders. However, vested business interests in the U.S. have successfully fought off every attempt to achieve our shared goal. Against that backdrop, we would welcome his support for the corporate governance changes that are being won through shareholder litigation. And once again, we have institutional investors to thank for their willingness to bring forward corporate governance based cases, known in the jargon as “derivative” actions. Our firm was honored to represent the international coalition of pension funds that won significant concessions from Rupert Murdoch and News Corp. Similarly, we helped the U.S. trade union, AFSCME, achieve the historic federal appeals court ruling against AIG that will enable proxy access for shareholders to nominate director candidates, long considered the “holy grail” for investor activists.

Our intention here has been to bring some balance back into the debate around the competitiveness of U.S., capital markets, and to give a different perspective on the reforms promulgated by the CCMR, among others. Shareholder litigation, far from being a drag on capital market competitiveness, promotes integrity by protecting investors. To alter the status quo now – in the wake of continued (and growing) corporate malfeasance – sends the message that accountability to shareholders is a goal not worth pursuing.

Tuesday, February 14, 2006

What is the Purpose of a Corporation?

Google CEO Eric Schmidt is quoted in Time Magazine this week as saying:  "The company isn't run for the long-term value of our shareholders but for the long-term value of our end users." 

I found this statement to be a bit startling coming from a CEO, but it raises a fair question: What is the purpose  of a corporation?  Is it to maximize long-term shareholder value?  Is it to maximize value to the people the corporation serves?  Are these mutually exclusive?  Or are these just different ways of saying the same thing?

I'm just a recovering securities litigator and I admittedly don't know these answers, but I'd love to hear what folks like Prof. Bainbridge, Ideoblog, and The Quant think about this.

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Tuesday, June 15, 2004

Should In-House Counsel's VP Title Cause Waiver of Privilege?

Back in the day, when I was a practicing litigator, a very senior federal judge who I will just refer to as "Judge Elderly" was complicating my life and the lives of my co-counsel by being extremely slow to rule on certain important motions. Leaving the courtroom one day after the judge's delays created yet another procedural quagmire, my co-counsel somberly deadpanned, "None of this would have happened if Judge Elderly was still alive."

I kind of feel the same way after learning, two months late, about the crazy factual scenario playing out in the case of Jasmine Networks v. Marvell Semiconductor in state court in California: I would have known about this long ago if Corp Law Blog was still alive! (just kidding, Mike!).

The case stems from the following lawyer-nightmare scenario, which I think blows right by the Seventh Circle of Document Review Hell in terms of sheer lawyer anguish: Three Marvell employees--Marvell's general counsel; its VP of engineering, and in-house patent attorney--gathered to call a person at Jasmine, a company with which Marvell was negotiating to purchase some technology. Using a speakerphone, the three left a message on the Jasmine employee's voicemail. However, after leaving the initial message, they failed to hang up the speakerphone, and proceeded to have a conversation that also was recorded on the voicemail.

To put the inadvertently left message in context, Marvell and Jasmine had entered into a nondisclosure agreement that protected the secrecy of Jasmine's trade secrets and employee information. To that end, Marvell was given an opportunity to look at the trade secret information, but not to remove it. Patent disclosures, among the most important of Jasmine's intellectual property, could be reviewed but not copied. Enough was to be shown Marvell to demonstrate the value without disclosing the secret. As summarized by the California Court of Appeals (Sixth District), the contents of the inadvertent voicemail "demonstrate[d] the theft of Jasmine's trade secret, the potential consequences and the planned cover up."

The lower court granted Marvell's request for a preliminary injunction enjoining Jasmine from disclosing, disseminating or referring to the contents of the recorded voicemail conversation. Marvell had argued that because the conversation involved its attorneys, its contents were subject to the attorney-client privilege. Jasmine appealed this ruling.

The Sixth District Court of Appeals reversed, finding that the privilege had been waived by Marvell because although an attorney's inadvertent disclosure does not waive the privilege absent the privilege holder's intent to waive, this rule did not apply because Marvell's general counsel was acting not only in that capacity, but also as the vice-president of business affairs and an officer of the corporation. In short, the appeals court held that because the general counsel also held the title of vice president and was an officer of the company, the fact that Marvell did not intend to waive the privilege through the inadvertent disclosure was immaterial.

This decision apparently has now been appealed to the Supreme Court of California, and has prompted the Association of Corporate Counsel to submit this amicus curiae letter. The ACC argues that the opinion, "if left standing, means that an in-house lawyer who is providing legal services, but who does so with a corporate title (such as 'vice president') attached to his business card, can inadvertently waive the privilege, contrary to the rule for all other attorneys." The ACC noted that more than 4,000 of its 16,000 members hold the title of "vice president," while many others hold similar titles such as Chief Legal Officer.

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Wednesday, December 3, 2003

25th Annual Institute on Critical Corporate Disclosure, Governance Issues & the Proxy Process

ISS, the American Society of Corporate Secretaries and Glasser LegalWorks will hold the 25th Annual Institute on Critical Corporate Disclosure, Governance Issues & the Proxy Process on December 8-9 in New York City and December 11-12 in San Francisco. Among other topics, senior members of the SEC's Division of Corporation Finance (including Director Alan L. Beller) will discuss the intricacies and requirements of the rules requiring expanded disclosure of nominating committee processes and new disclosures concerning shareholder communications.

For details on this event, click here.

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Tuesday, December 2, 2003

Two More Years! Two More Years!

Today's edition of Compliance Week has an interesting bit of research on which public companies have the oldest acting directors currently serving on their boards. According to Compliance Week, there are no current directors at the century mark, but George Kane of Panera Bread Co. is knocking on the door at age 98. It's gotta be the bread!

Other notables:

Howard LeFevre: Park National Corp., age 95.
Max Fisher: Comerica Inc. and Sotheby's Holdings, age 94.
Theodore Rosenberg: ABM Industries, age 94.

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Monday, October 20, 2003

20,000 Hours to Comply With SOX?

Anecdotal evidence of the immense cost of complying with Sarbanes-Oxley, particularly the internal controls provision in Section 404, is starting to surface as next year's deadlines grow nearer. According to this article in USA Today, the CEOs of Fortune 500 companies Affiliated Computer Services and Steelcase say it will take their companies 20,000 staff hours to comply, the equivalent of 10 people working full time for a year. Other companies such as Dell estimate that compliance will take closer to 5,000 hours.

As discussed here previously, the SEC's Final Rule regarding Section 404 estimated an average 383-hour workload per company, a figure that was raised from the SEC's original estimate of just 5 hours after strong comments such as this one from Intel's Cary Klafter advised the SEC that its had "underestimated the time and effort involved in complying with these rules by at least a factor of 100, if not a greater order of magnitude." The numbers in the USA Today article suggest that Klafter could have added another zero to the end of that prediction and still have been correct.

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Tuesday, October 14, 2003

"Pathological Aversion and an Immunodeficiency" to Lawyers

The following article appeared in the October 10, 2003 edition of ISS's The Friday Report:

Breeden: WorldCom to be Governance Proving Ground
By Michael P. Bruno, Staff Writer

BOSTON, Oct. 8—Richard C. Breeden thinks it's a bad sign when your CEO has more in common with Julius Caesar than with his employees.

A prime example is Bernie Ebbers, the fallen chief of WorldCom Inc., the telecommunications services provider at the center of the largest bankruptcy and accounting fraud case ever. Ebbers was given "near imperial reign" according to Breeden, a former SEC chairman and the telecom company's court-appointed corporate monitor.

"Wearing the laurel wreaths is also another clue that you have a CEO who perceives his role as being more akin to that of a Roman emperor than to a business leader, and that certainly was something that went on for years at WorldCom," said Breeden.

Breeden kicked off the ComplianceSolutions Boston 2003 conference with a keynote address about lessons learned from WorldCom and the 124-page legal tome called "Restoring Trust," where he laid out 78 governance changes the company must make. In turn, WorldCom, which is changing its name to MCI, will become the leading testing ground for corporate governance ideas, he said.

"Over the next two years, as these recommendations are phased in, you're going to have a very large laboratory because every one of them is going to be followed," the chief executive of Richard C. Breeden & Co. told conference attendees.

The turnaround consultant didn't mince words in rehashing what should have been clues to WorldCom employees and watchers that the business was in trouble. "Bernie Ebbers was as incompetent and unqualified to be a chief executive officer as any person who ever held that post," Breeden said.

Among his list of clues was Ebbers' "pathological aversion and an immunodeficiency" to the company's legal department. The company had lawyers everywhere, just not in Clinton, Miss., where Ebbers worked, Breeden said. "The tone at the top there was, ‘Take what you can get;' not respect for the law and concerns about little issues like ethics or integrity."

The board of directors, while it had some "good" members, was on the whole "weak and ineffective," according to Breeden. While eight of the 10 directors officially met the New York Stock Exchange's standards of independence, in reality only "1.6" were detached.

"WorldCom was a classic case where the board was rife with cronyism. One of the directors was there for a really good reason: He was the next-door neighbor of Bernie Ebbers," Breeden said.

Moreover, in the year leading up to WorldCom's implosion, the board's compensation committee met 17 times while the whole board met just four times. And while the board approved a $238 million "sack of cash" for Ebbers to hand out for employee retention—"talk about hush money," Breeden said—there wasn't a contract in place for severance if Ebbers were fired.

"The idea of being fired never occurred to Mr. Ebbers," he said. (When Ebbers was fired, the board agreed to a severance package that would have been worth about $250 million had it been honored at the time, on top of a $408 million loan that was forgiven.)

WorldCom will emerge from bankruptcy around Jan. 2, 2004, with around $20 billion on its balance sheet, Breeden said. That's down from the $104 billion that was reported, and apparently much inflated, in March 2002. He said the new MCI "will" emerge despite complaints from rivals Verizon Communications Inc. and AT&T Corp., and the roughly $20 billion will make for the largest emergence in history. Meanwhile, the "victim trust"—the $250 million equity stake under the SEC's $750 million settlement for injured investors—will own 3.3 percent of the telecom company after bankruptcy.

Under Breeden's report, the company must install new internal controls. But even with "hundreds" of consultants helping the company, it will take at least five years to fully install them, he said. Meantime, MCI CEOs from now on must pledge to an ethics agreement and can be fired if they violate it.

"The WorldCom case is worth study at all our universities and all of our major companies because it really did happen," Breeden said.

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