Securities class action lawyers are preparing for the next wave of shareholder lawsuits as more companies and their top executives face federal probes and accounting restatements linked to the backdating of their stock options.
Dozens of shareholder suits have been filed recently on behalf of large institutional shareholders by a number of law firms, including well-known plaintiffs firms Bernstein Litowitz Berger & Grossmann of New York and Lerach Coughlin Stoia Geller Rudman & Robbins of San Diego. The suits allege that certain companies backdated stock options granted to executives to enhance the profits made by those executives when they exercised the options.
Backdating stock options is at the heart of recent inquiries by the Securities and Exchange Commission and the Justice Department. As of earlier this summer, more than 60 companies � including Microsoft and Apple Computer � had announced that their option practices were under review. Some companies have already restated their earnings or ousted top executives. In addition to investigating specific companies, the SEC also may respond to the options-dating controversy by revising the new pay disclosure rules it proposed in January.
Meanwhile, federal lawmakers have been debating in recent weeks whether to seek regulations that are stricter than those being proposed by the SEC regarding executive compensation. “This is probably the biggest corporate scandal since the Enron days,” says Mario Alba, a lawyer at Lerach Coughlin, which has been investigating some 30 companies for potential lawsuits over the backdating of stock options. “These companies are manipulating their books to make themselves look profitable.”
But some lawyers say that the cases will be difficult to prove and will also face challenges over statutes of limitations. “It’s going to turn a lot on the facts and circumstances,” says Joseph Serino, a partner in the New York office of Kirkland & Ellis. “The plaintiffs are going to have to prove fraudulent intent, and that’s not easy to prove.”
The issue of backdating first came to light earlier this year after a series of media reports questioned why top executives at several companies had unusually good luck in obtaining grants of shares just before large upswings in value. Since then, federal authorities have contacted dozens of companies including KLA-Tencor Corp., McAfee Inc., Analog Devices Inc. and UnitedHealth Group Inc., which announced in May that it might have to restate earnings by as much as $286 million due to improper stock-option backdating.
Other companies have restated earnings or fired executives following their own internal investigations. Sycamore Networks Inc. announced recently that it received a grand jury subpoena and that the SEC has launched a formal investigation into the company’s stock option practices. Sycamore has since restated its financial reports from 2000 to 2005. McAfee’s board, meanwhile, fired its general counsel, Kent Roberts, after discovering that he had received improper stock-option grants in 2000.
“Anytime you have allegations of regulators and corporations issuing any kind of mea culpa, that is the bat phone ringing in the law firms of plaintiffs’ lawyers,” says Serino. Stock-option backdating is a “gigantic issue” for institutional investors, many of which have brought the suits, adds Rosemary Lally, an editor at the Council of Institutional Investors in Washington, D.C. “It involves an awful lot of money,” she says.
Plaintiffs’ firms have been filing two types of shareholder suits over stock options backdating: derivative claims and securities actions. Most of the derivative claims allege breach of fiduciary duty and are filed by institutional shareholders on behalf of the company as a whole. They seek the return of the stock options.
Bernstein Litowitz, for example, recently filed a derivative suit in federal court in Minnesota on behalf of five public pension funds alleging that top executives of UnitedHealth regularly received stock options at annual lows. The funds are asking that $2 billion in unexercised stock options, which were granted to two of the executives between 1997 and 2002, be returned to the company, according to Gerald Silk, an attorney at the Bernstein firm.
Although the UnitedHealth suit is the first filed by Bernstein Litowitz over stock option backdating, Silk says he has been discussing additional lawsuits with other clients. “I imagine there will be other lawsuits in the near future on behalf of our institutional client base against these companies,” says the lawyer.
Two other UnitedHealth suits, filed by Grant & Eisenhofer, a firm in Wilmington, Delaware, recently joined with Bernstein’s case and are awaiting the appointment of a lead counsel. But Jay Eisenhofer, managing partner of the Grant firm, acknowledges that it could be difficult to prove breach of fiduciary claims. “The rules are set up so that honest directors can operate without shareholders suing them every time they make a mistake,” he says. “Those same rules can also operate to protect dishonest directors and management from being accountable for things like this.
Calls seeking comment from UnitedHealth were not returned.
Other lawyers have sued companies over backdating stock options by bringing standard securities class actions, citing anti-fraud provisions of the U.S. Securities Exchange Act of 1934. Those suits are seeking damages caused to individual shareholders who allege that they were misled by statements in the financial reports.
Several suits have been filed against Affiliated Computer Services Inc. and Vitesse Semiconductor Corp., which have been contacted by both the SEC and the Justice Department. In May, Lerach Coughlin filed a securities action against Comverse Technology Inc. on behalf of shareholders who purchased stock between December 2004 and March of this year. The lawsuit alleges that Comverse issued false financial reports because of backdated options granted to two of its executives, founder and chief executive Kobi Alexander and David Kreinberg, the company’s chief financial officer. The suit was filed two days after those executives resigned.
Alba, one of the Lerach lawyers handling the case, says he expects the firm to file derivative suits, which require more investigation. “A lot of people have them in the woodwork rather than spinning out one after the other,” says Alba. Comverse officials declined to comment on the pending litigation.
The plaintiffs’ bar faces several challenges in both types of suits. Serino, the Kirkland & Ellis attorney, says that companies may claim that low prices on the shares’ exercise dates were a coincidence or innocuous. Also, the damages could be limited. “I’m not sure these are going to be huge dollar cases unless it’s really, really widespread and lots of executives are at one particular company,” he says.
Defense attorneys are also quick to point out statue of limitations issues with the recent stock-option backdating cases. Bruce Vanyo, a partner in the Los Angeles office of Katten Muchin Rosenman, notes that the statute of limitations under the Sarbanes-Oxley Act is two years from the date of discovery and five years from the event, and that many of the pending suits involve options granted more than five years ago.
But Vanyo also says that attorneys could argue that Sarbanes-Oxley, which extended the statute of limitations under the Securities Exchange Act, does not apply retroactively to options granted before 2002. Some plaintiffs’ lawyers have argued that because the backdating was only recently revealed, the suits fall within the two-year discovery time limit.
Amanda Bronstad is a reporter at The National Law Journal, an ALM publication affiliated with GC California.