Study Shows Investor Sensitivity to Class-Action Accounting Allegations

By Will Boye, Managing Editor

A recent study of how stock prices move in response to various events in the securities class-action litigation process reveals that investors are more sensitive to allegations involving accounting fraud, particularly for revenue items, than other allegations.

The study also points to an increased interest in securities class-action suits in recent years, according to Paul Griffin, a professor of management at the U.C. Davis Graduate School of Management who authored the study with Joseph Grundfest, a professor at Stanford Law School, and Michael Perino, a professor at St. John's University School of Law.

The study, which was based on filings over the past 12 years in the Securities Class Action Services database, found that issuers' stock prices dropped more than 24 percent when the company disclosed accounting violations at the end of the class period. For companies that disclosed non-accounting violations at the end of the class period, the corresponding drop in the stock price was 8.9 percent.

"The response to the accounting announcements tends to be larger," Griffin told SCAS Alert. "It's more clear to an investor that something is actually taking place that was wrong when there's disclosure of a restatement or an accounting correction versus something else that may be more difficult to prove, such as a violation of insider trading or a violation of fiduciary duty."

The data from the study also shows that investors' negative response to class-action filings, shown in the corresponding drop in issuers' stock prices, has grown larger in recent years, a trend that Griffin believes reflects a growing interest in securities class-action cases themselves.

"There could be more or renewed interest now on following firms that are subject to class-action filings," he said. "And that makes sense because certainly there's a lot more interest in securities litigation now than there used to be, partly because of the Private Securities Litigation Reform Act (PSLRA)."

The study, which improved upon a 2000 study that used a smaller sample of filings, examined stock movements surrounding three dates that define securities class-action litigation: the beginning of the class period, the end of the class period (denoted by a corrective disclosure of some kind), and the class-action filing. Griffin found that investors responded to the three events sequentially and not as unrelated events. For example, when the price decline at the date of the corrective disclosure was larger than average, then the decline at the date of the filing tended to be smaller, indicating that the market was less surprised by the news.

In a more limited sample, Griffin found that firms' stock prices increased by 3 percent in the days surrounding the announcement of a class-action settlement. But the results are less conclusive here, Griffin said, because it's more difficult to determine precisely when the market learns about a settlement.

"It's a little bit more difficult relative to something like a corrective disclosure, where everybody learns about it pretty much on the same day," he said. "I suspect a larger sample would still show the same kind of response."

State-Federal Conflict and the WorldCom Quagmire

By Bruce Carton, Executive Director

Oklahoma Attorney General Drew Edmonson filed criminal charges on Aug. 27 against WorldCom Inc. (renamed MCI) and six of its former executives, including former CEO Bernie Ebbers. Oklahoma alleged that WorldCom and the individual defendants' conduct with respect to the company's now well-publicized accounting irregularities constituted criminal violations of the Oklahoma Securities Act.

Such conduct, of course, is the same that has been under investigation by the U.S. Attorney's Office for the Southern District of New York (SDNY) and the U.S. Securities and Exchange Commission (SEC) since June 2002. Predictably, the SDNY and the SEC were quick to express their displeasure. Both immediately issued press releases making it clear that Oklahoma's action had blindsided them and expressing hope that their ongoing cases would not be jeopardized.

Neither the SDNY nor SEC provided any real specifics on how Oklahoma's case might negatively impact their own cases, leading some, including members of Congress, to speculate that their protests were largely "P.R.-related;" i.e., motivated by a concern that Oklahoma was stealing their thunder. Indeed, when SEC Chairman Donaldson recently told the House Committee on Financial Services that Oklahoma's actions were "dangerous," he was confronted by Rep. Barney Frank (D-Mass.). The ranking Democrat on the committee challenged the SEC chairman to name instances where state action had hurt federal action and asked Donaldson to send him a list. Frank then commented, "I think the list is going to be very short."

In this instance, however, Oklahoma's decision to proceed with its own case does appear to be a poor one that may well do harm to the existing federal cases. Oklahoma brings nothing unique to the table here. It is bringing this case merely in its capacity as one of the dozens of states with citizens affected by the fraud at WorldCom. Asked why his office was bringing the case, Edmonson reportedly cited a "lack of accountability," and stated that "the lack of any serious sanction against WorldCom, either corporately or its individual officers is the most compelling reason." Now, Edmonson predicted, "somebody's going to go to prison."

Edmonson also makes no apologies for his failure to coordinate with the Feds, reportedly stating that he wrote to the SDNY prior to taking action but never received a response. Edmonson is even more abrupt with respect to the efforts of the SEC. The New York Times quoted him as saying, "I haven't seen much of that so I don't think there is much to interfere with."

Notwithstanding Edmonson's cavalier attitude toward the existing federal cases, Oklahoma's decision may have a significant impact on the SDNY and SEC. Several prominent attorneys who spoke to me about the case gave compelling examples of how that could happen.

Damaged witnesses. From all reports, Oklahoma and the SDNY/SEC are pursuing the same company and the same individuals for the same conduct under the same theories. Thus, Oklahoma will soon be bringing common witnesses to testify before its own grand jury and at trial. Attorney Alex Bourelly noted that such testimony will effectively "lock in" the testimony of these witnesses, facilitating cross-examination by counsel for the defendants in any later federal action. Bourelly is special counsel with the law firm Baker Botts in Washington, D.C., and is a former assistant U.S. attorney in the Fraud and Public Corruption Section in the U.S. Attorney's Office for the District of Columbia.

Bourelly points out that because the Oklahoma prosecutors have not been immersed in the case and the millions of documents produced to the SDNY and SEC over the past 15 months, testimony may be locked in that does not take full advantage of facts and theories developed by the federal prosecutors. This possibility places the Feds in the difficult position of deciding whether to devote substantial resources to coordinating with and educating Oklahoma, or to decline to do so and risk damage to their own cases.

Adverse Rulings. The "double jeopardy" doctrine will not bar a subsequent prosecution by the federal government following a possible acquittal in the Oklahoma case because they are different "sovereigns." Nonetheless, David B. Irwin, a former assistant U.S. attorney in Maryland, and now a partner with Irwin, Green & Dexter in Baltimore, points out that adverse evidentiary or other rulings in the Oklahoma case could still harm the federal cases because a federal trial court might well give weight to such rulings in reaching its own decision on the issue.

Immunity Tangles. If Oklahoma gives immunity to witnesses asserting the Fifth Amendment privilege, the existence of such immunity may taint and hinder the Feds' ability to present related evidence in a subsequent case. Irwin notes that similar immunity issues arose in the federal case against Oliver North that followed a congressional inquiry, and the state case against Linda Tripp that followed the Whitewater grand jury investigation.

Deterrence to Settlement. State enforcement actions like the one brought by Oklahoma have the potential to significantly hinder the SEC's ability to settle its cases. Michael J. Rivera, a former attorney in the SEC's Enforcement Division, and now a partner with the law firm Fried, Frank, Harris, Shriver & Jacobson, believes that defendants facing an SEC enforcement action may be inclined to litigate rather than settle if they have a reasonable fear that any one of 50 states may decide to file its own enforcement action based on the allegations or findings contained in the defendant's settlement agreement with the SEC. Defendants seeking to resolve an SEC investigation crave comfort that an SEC settlement will resolve all potential government actions against them, Rivera added.

These reasons are all in addition, of course, to the inefficiency of having federal prosecutors and one or more states prosecuting the same defendants for the same conduct.

The furor over Oklahoma's actions has produced one positive development. The SEC and the North American Securities Administrators Association announced on Sept. 14 that they will form a joint initiative to develop best practices for the coordination of federal and state enforcement activities. The stakes are high: preventing a repeat of the WorldCom quagmire.

TENTATIVE SETTLEMENTS

NewPower Holdings Inc.

In a tentative settlement related to Enron Corp. and its Raptor III partnership, NewPower Holdings—a company created by Enron—has agreed to pay $26 million to settle a class-action lawsuit that was filed in February 2002 in U.S. District Court for the Southern District of New York and two jointly-administered bankruptcy cases currently pending in U.S. Bankruptcy Court for the Northern District of Georgia. Investors who purchased the common stock of NewPower Holdings during the period from Oct. 5, 2000, through Dec. 5, 2001, are expected to be eligible to take part in the settlement.

The complaint alleges that the Registration Statement and Prospectus for NewPower's public offering on Oct. 5, 2000, was false and misleading in several ways, including misrepresentations and omissions concerning the adequacy of risk management systems put in place in conjunction with NewPower affiliate, Enron Energy Services Inc. (EES) and the true nature and purpose of certain related party transactions. The transactions at issue included those pursuant to which Enron allegedly attempted to hedge its investment in NewPower through use of a partnership known as "Raptor III," which was conceived and designed by Enron CFO Andrew Fastow. Furthermore, NewPower Holdings and certain of its officers and directors allegedly misrepresented or failed to disclose: (i) that the company had not adopted effective and appropriate hedging strategies against volatility of commodity prices; (ii) that the company was on course to achieve its financial goals and had sufficient liquidity to do so; and (iii) that certain forward contracts with EES posed little risk of loss when they were actually driving the company toward insolvency, and were largely structured to protect and enrich Enron, NewPower's controlling shareholder.

NewPower is a retailer of gas and electricity, which maintains its headquarters in Purchase, N.Y. The company was formed by Enron in 1999 and began servicing retail customers in Pennsylvania and New Jersey in August 2000.

DISMISSALS

Foundry Networks Inc.

A class-action lawsuit that was filed against Foundry Networks in January 2001 in U.S. District Court for the Northern District of California has been dismissed. The lawsuit was filed on behalf of purchasers of the common stock of Foundry Networks during the period from Oct. 18, 2000, through Dec. 19, 2000.

The complaint alleged that Foundry concealed and misrepresented certain problems it was experiencing that were impacting its future revenue growth, including the fact that many of its customers were having difficulty raising money. Foundry allegedly concealed this information so that the individual defendants could sell additional Foundry shares before the bottom fell out of its stock price.

According to the company, Foundry is a provider of high-performance enterprise and service provider switching, routing and Web traffic management services including Layer 2/3 LAN switches, Layer 3 Backbone switches, Layer 4 - 7 Web switches and Metro Routers. Foundry's 6,000 customers include the world's premier ISPs, Metro service providers, and enterprises including e-commerce sites, universities, entertainment, health and wellness, government, financial, and manufacturing companies.

NVIDIA Corp.

A class-action lawsuit that was filed against NVIDIA Corp. in February 2002 in U.S. District Court for the Northern District of California has been dismissed. The lawsuit sought to represent investors who purchased the common stock of NVIDIA during the period from Feb. 15, 2000, through Feb. 14, 2002.

The complaint alleges the following: As part of their effort to boost the price of NVIDIA stock, defendants misrepresented NVIDIA's true prospects in an effort to conceal NVIDIA's improper acts until they were able to sell at least $66 million worth of their own NVIDIA stock. In order to overstate revenues and assets from the fourth quarter of 2000 through the third quarter of 2001, NVIDIA violated generally accepted accounting principles (GAAP) and SEC rules by engaging in an illegal accounting scheme. This scheme had the effect of dramatically overstating revenues and assets. Then, on Feb. 14, 2002, after the close of the market, the company partially admitted in a press release that its past accounting for its prior results may be inaccurate.

According to the company, NVIDIA is a visual computing technology business, dedicated to creating products that enhance the interactive experience on consumer and professional computing platforms. NVIDIA is headquartered in Santa Clara, Calif., and employs more than 1,600 people worldwide.

• Cadence Design Systems Inc.
• Micro Focus Group PLC
• VisionAmerica Inc.
• Windmere-Durable Holdings Inc.

Leading U.S. Public Pension Funds Press for NYSE Reforms

America's four largest public pension funds are playing a leading role in forcing changes at the world's largest stock exchange. The funds, which represent assets of roughly $400 billion, played a pivotal role by calling for the ouster of New York Stock Exchange CEO and chairman Richard Grasso following the disclosure of a deferred-compensation- and pension-related package totaling $187.5 million. California state treasurer Phil Angelides, together with the heads of the California Public Employees' Retirement System (CalPERS), the California State Teachers' Retirement System, and N.Y. State Comptroller Alan G. Hevesi, trustee of the Empire State's pension fund, the nation's second largest after CalPERS, demanded Grasso's ouster in a press conference on Sept. 16. The NYSE board ousted Grasso the next day. But the state officials and pension funds remain vocal in pressing for more reform at the Big Board. The group met with 11 NYSE directors on Sept. 24, urging the NYSE to separate its business and regulatory functions, separate the roles of CEO and chairman, and cut the size of its board.

New York State Comptroller Alan Hevesi unveiled a new institutional investor-based corporate governance group at the Council of Institutional Investors (CII) annual fall meeting in early September. He said the group, which he called the National Coalition for Corporate Reform, could use lawsuits as a tool for reforming companies and gaining restitution for injured investors.

But in a possible setback, CalPERS voted not to become a member of the coalition immediately, citing the potential drain on its own governance efforts and resources. Following a recommendation by Ted White, CalPERS' director of corporate governance, the investment committee voted to participate in the formative stages of Hevesi's coalition but to consider joining as a full-fledged member at a later date.

David Neustadt, a spokesman for Hevesi, later told ISS's Friday Report that, to his knowledge, CalPERS representatives are planning on attending the first organizational meeting but that no one has been invited to join the NCCR as of yet. "There is no organization yet," Neustadt said in mid-September. "I'm glad that they've had a discussion of the pros and cons of joining something that hasn't been formed yet."

Mel Weiss, the king of class-action lawyers and the scourge of underperforming companies, has targeted Exegenics Inc., but this time it's personal. Weiss and his family own 4 percent of the stock, the Financial Times reported. Along with suing the struggling biotechnology company for allegedly mistreating its investors, Weiss is for the first time going after its directors. Weiss has filed with the SEC in an effort to remove Exegenics' board, a move that would require half of all shareholders' support.

The tactics contrast with his usual approach in class-action suits, which have frequently been attacked by his critics as "shake-downs" because boards and managements often prefer to settle allegations out of court to avoid publicity and expense, the Times said.

SEC Chairman William H. Donaldson, testifying on Capitol Hill, laid out an unfinished agenda of securities regulatory issues. Topics included defining state-level action, requiring corporate attorneys to "report out" to the SEC, and examining the self-governance of the NYSE and other stock exchanges. Donaldson made the comments Sept. 17 before the House Committee on Financial Services.

In an exchange with House Capital Markets Subcommittee Chairman Richard H. Baker (R-La.), Donaldson told the House Financial Services committee that a new joint task force between the SEC and the North American Securities Administrators Association would focus on developing an assignment protocol of enforcement efforts of state and local governments. The joint group—which the SEC and NASAA announced days before—comes after SEC and certain states' officials, such as in Oklahoma and New York, have butted heads over enforcement actions. [See Point of View Editorial for more.]

In other issues, Donaldson said the commission still has not made up its mind on what further to require from corporate attorneys. While encouraged by the American Bar Association's adoption of new ethics codes this summer that allow lawyers to tell the SEC about misbehaving companies, the SEC chairman declared that the proposition of "noisy withdrawal" remains alive. "We have not written a rule on this yet; we have it under consideration," he said.

An outside director at Tyco International Ltd. said the conglomerate should quickly resolve shareholder lawsuits spurred by suspect accounting practices and fraud claims against former executives, Reuters reported, attributing an in-house Tyco newsletter.

"We have to get the shareholder suits behind us as soon as possible so we can concentrate on what is the real business of Tyco, which is manufacturing products for customers and making money for shareholders," the newsletter quotes director George Buckley as saying. He is chief executive of boatmaker Brunswick Corp.

Jack Krol, Tyco's lead outside director and a former CEO of chemical maker DuPont Co., said the resolution of pending regulatory investigations and shareholder lawsuits are among the company's toughest challenges, according to the newsletter.

Securities fraud claims against Tyco have been consolidated in U.S. District Court in New Hampshire, where Chief Judge Paul Barbadoro is weighing the company's motion to dismiss the class-action complaint. Lawyers involved in the lawsuits said there have been no settlement talks, Reuters reported.

The net result of providing restitution to investors from recent corporate scandals is often likely to be pennies or dimes on the dollar for injured investors, the Wall Street Journal reported. According to late summer estimates by the SEC, payouts to investors in WorldCom will run about 10 cents a share. To put that in perspective, WorldCom shares were trading for 83 cents the day before the fraud was disclosed, but had climbed as high $64.50 at their peak in June 1999.

Still, there is a lot of money—and more all the time—earmarked for distribution to investors, the Journal reported. Last year, in response to the Enron Corp. and WorldCom scandals, Congress gave the SEC new powers designed to get more money into investors' hands. Since that law, known as the Sarbanes-Oxley Act, took effect in mid-2002, the SEC has set up at least 29 distribution funds with roughly $1.5 billion in assets. That includes $399 million for investors hurt by analyst conflicts of interest; the fund was largely collected from major investment banks that were issuing research allegedly tainted by their investment-banking relationships.

Trend: Legal Woes Induce Corporate Giants to Embrace Governance Reforms

Public companies under fire in courtrooms, often from institutional investors, are agreeing to corporate governance reforms as part of their legal resolutions. At least six major companies this year, including MCI (formerly WorldCom Inc.,) have announced significant changes including bolstering board independence levels and better oversight of executive compensation.

At MCI, which is in a record-making bankruptcy proceeding and under separate court supervision for the largest corporate fraud case ever, a court-appointed monitor issued a long-awaited report in late August outlining 78 reforms. MCI's board unanimously adopted the reforms, which include:

• Limiting CEO pay to $15 million per year
• Basing directors' annual pay at $150,000, 25 percent of which must go to buy MCI stock
• Capping directors to 10-year terms and mandating retirement at age 75
• Starting in 2005, selecting one director who should not be renominated each year, to permit the election of a new director
• Abandoning new stock options in favor of restricted stock, and expensing equity grants
• Abolishing short-term earnings projections and emphasizing cash flow over earnings before interest, taxes, depreciation, and amortization (EBITDA)
• Paying 25 percent of its earnings to shareholders through dividends.

Meanwhile, Siebel Systems Inc. was facing an early November trial date for a shareholder lawsuit led by the Teachers' Retirement System of Louisiana, which charged the software giant with allocating more stock options to executives than had been approved by shareholders. To settle the case, the company in late August agreed to:

• Add a new member to its board to be nominated at the company's next annual stockholders meeting
• Create and disclose more specific criteria for the selection of future directors, as well as the criteria used by the compensation committee to set awards to executives, directors, and employees
• Expand the size of the compensation committee, which is to consist solely of independent directors
• Boost the size of the nominating and corporate governance committees
• Limit the compensation of directors to a preset level that has been disclosed to shareholders
• Provide annual disclosure of the value of options granted to directors and the company's five highest paid employees.

Siebel did not immediately provide details of its new criteria or other plans to enact the reforms.

MCI and Siebel were not alone in accepting governance reforms. Independent directors of Computer Associates International Inc. announced at the company's annual shareholder meeting that they were considering adding one or more independent directors to the board, Dow Jones Newswires reported. Federal authorities are investigating the company's accounting, and in recent years CA has been the focus of angry shareholders led by Sam Wyly. The company paid him $10 million last year to drop his proxy contest efforts.

CA asserts it has revamped its board, adding independent members and instituting term limits, and it points out that it has begun expensing stock options. The company also agreed to settle a collection of shareholder lawsuits in late August by issuing 5.7 million shares to plaintiffs who had alleged accounting misdeeds, Dow Jones said.

In August, Homestore Inc. agreed to pay $63.6 million in stock and cash to settle a class-action lawsuit with CalSTRS. Under the tentative settlement, the online real estate technology company agreed to two-year board terms, adding a new shareholder-appointed director and minimum stock ownership requirements for directors, the Associated Press reported. Homestore further agreed not to use stock options for future director compensation.

Likewise, Hanover Compressor Co. shareholders with more than 1 percent of the company's common stock will be allowed to nominate two independent directors to the company's board under a lawsuit settlement with GKH investment groups. Hanover is a provider of natural gas compression services. It agreed in May to the settlement, which also provides investors with more than $80 million in cash, stock, and debt instruments. Hanover also agreed to rotate its independent auditor every five years.

And in late March, Sprint Corp. agreed to groundbreaking changes as part of a settlement of shareholder lawsuits following the failed merger with WorldCom. Sprint's board unanimously approved a set of reforms involving independent director and board standards, the end of staggered terms, limitations on compensation and stock options, and other measures. In addition, Sprint agreed to pay $50 million in cash to settle one of two shareholder suits filed against the company and led by Amalgamated Bank of New York. By the time of the settlement, Sprint had already decided to expense stock options and form a nominating and corporate governance committee.

This article originally appeared in ISS's Friday Report