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As two recent securities lawsuits illustrate, there are no guarantees when you go to court.
Alix Stuart, CFO Magazine
April 1, 2008
When it comes to class-action securities lawsuits, the operative question is usually when, not whether, to settle. Last fall, however, two companies and their executives ignored that dictum and chose a different path: they called their shareholders' bluff and went to trial.
One, JDS Uniphase, put former CFO Anthony Muller and other former executives on the stand amid shareholder claims of fraud and insider trading related to the telecom's 2001 loss of $50.6 billion, still one of the largest in history. The second, Apollo Group Inc., had former executives, including CFO Kenda Gonzales, defend their 2003 decision to initially conceal a preliminary — and negative — Department of Education (DoE) report against the private education company. The total at stake for both companies: up to $20 billion in alleged stock losses.
Few companies have the fortitude to gamble on a judge and jury. Only 20 federal class-action shareholder lawsuits (including these 2) out of the 2,682 filed since 1995 have gone to trial, according to RiskMetrics Group, and 7 of those settled before the juries could reach their verdicts (see the chart link at the end of this article).
The road to the courthouse is starting to look more attractive, however, as the price of settling skyrockets. "The tremendous increase in the dollar value of settlements has greatly altered the economics of securities class cases," says Steven Scholes, a partner with McDermott Will & Emery. The average settlement spiked from $24.6 million in 2004 to $105 million in 2006, according to Cornerstone Research, and many top the $1 billion mark. "You can see how the balance would tip toward going to trial, if you have a good defense," says Scholes.
For all those CFOs who sincerely believe they have a good defense against a frivolous shareholder lawsuit, last fall's trials serve as both inspiration and warning. JDS Uniphase walked away from the courthouse exonerated. Apollo Group faces a verdict in the full amount of damages sought, plus the risk of losing its insurance.
Why did one company win and the other lose? A look behind the scenes reveals how complex and unpredictable these cases can be. In addition, they illustrate that even when the preponderance of evidence appears to favor the company, there is no guarantee the outcome will. But one thing is clear: win, lose, or settle, there's no such thing as a cheap class-action suit.
If you had placed bets on the outcomes of the trials, Apollo would have been a clear favorite to win. Phoenix, the home of Apollo's corporate headquarters and its trial, is known as a business-friendly jurisdiction. Lead attorney Wayne W. Smith, a partner with Gibson, Dunn & Crutcher, felt sure that the jury was impartial and intelligent, based on pretrial interviews. The issue seemed fairly simple to explain, there were no charges of insider trading to defend, and the company had the analyst who broke the news of the DoE report lined up in a videotaped deposition to explain why her downgrade wasn't linked to that assessment.
JDS Uniphase, on the other hand, had the deck stacked against it from the start. The trial took place in liberal and diverse Oakland, California, close to JDS Uniphase's headquarters, which meant that the jury would most likely be hostile to business. Getting the defendants to connect with a jury could also be a challenge, as former CEO Jozef Straus had a thick Hungarian-Slovak accent that made him difficult to understand. Plus, there were those niggling hints of insider trading that made the executives look bad no matter what may have actually transpired. CFO Muller sold $35 million worth of stock months before it lost 99 percent of its value; other former executives made hundreds of millions selling the stock before it tanked.
"Those are the things you would look at and think were important but in the end didn't matter," says Adam Savett, head of securities class-action services for RiskMetrics.
What did matter? JDS Uniphase lead attorney Jordan Eth, a partner at Morrison & Foerster LP, credits his win to the credibility of his defendants. "They came across as they were: hardworking veteran execs, one of whom was a co-founder, who had spent their careers building up companies."
The company's basic defense was that none of the executives foresaw the collapse of the telecom industry that brought down JDS's stock starting in late 2000, and therefore did nothing improper by not warning shareholders (or by selling their own stock). Muller's turn on the stand allowed him to show appropriate passion for his former company — he "loved" his job at JDS Uniphase — and drop a mention of an altruistic retirement pursuit, helping low-income youth go to college. He also had a chance to turn on the charm, poking fun at himself as the "company worrier."
As to the insider trades, the defense highlighted that Muller's sales represented less than 20 percent of his total holdings, and that he'd had a practice of selling in the same month in previous years. "The fact that people kept to their previous practices is what you'd actually expect, rather than being suspicious," says Eth. No doubt the jury was also sympathetic to the reasons that Muller stated for selling: he wanted to diversify his holdings, since more than 90 percent of his net worth at the time was in JDS Uniphase stock, and plan for his impending retirement, since JDS didn't have a retirement plan or retiree health benefits.
When it came to defending JDS Uniphase's 2001 $45 billion write-off, executive presence was crucial, as well. "Tony [Muller] showed that he did a conscientious job by having processes set up and people he relied on, at the controller level and below," says Eth. The defense also called the former chair (and a current member) of JDS Uniphase's audit committee, Bruce Day, who "fortified the impression that the finance organization was thoughtful about what they did, and sought advice when presented with complicated issues," including how to handle the write-off with the Securities and Exchange Commission. "It's easy for people who are sophisticated to think juries are not," adds Eth, "but this case shows that you can explain yourself and they will listen."
Of course, a stint on the witness stand can go awry regardless of how likable the defendants are. With a total of three days on the stand, including a videotaped deposition, Apollo's Gonzales showed herself a dedicated worker, driving 180 miles a day to finish her college degree when her husband was transferred mid-program, and a parent who took her children on vacation to celebrate their graduations. She also had the chance to explain that part of the reason she chose not to reveal the DoE report was that she found it "very unprofessionally prepared," full of "inflammatory language" that was based on admittedly incomplete research, and mostly unrelated to actual violations. But thanks to a grueling cross-examination, Gonzales may have harmed Apollo's case when she told the jury that the company had not wanted the report "tried in the press" and so told investors that a review was ongoing but did not reveal the negative preliminary report. "The jury saw that the defendants themselves said it was a devastating report," and still didn't disclose it, says Stephen Basser, a partner with Barrack Rodos & Bacine, lead attorney for the plaintiffs.
The jury's interpretation of the law also worked against Apollo. The jury "seemed to conflate all the issues down to the question of 'If I were an investor, would I have wanted to know about this report or not?'" says lead attorney Smith, rather than whether or not the firm had a legal duty to disclose the information. In addition, Smith believes that the jury took an individual investor's view, rather than that of the institutional investors that held most of Apollo's stock. That made the difference when the jury had to decide whether or not the 5 percent stock drop on September 21, 2004, was in response to an analyst downgrade issued two days earlier. "A market professional will tell you that if the downgrade were going to move the market, it would have moved it immediately," says Smith. The jury, however, concluded that the two were linked and found Apollo liable for $5.55 a share, or somewhere between $160 million and $270 million, depending on how many shareholders come forward.
Trail to Trial
If the JDS Uniphase and Apollo Group cases illustrate the uncertainty in going to court, so, too, do the other 20 cases that have gone to trial. The initial allegations are wide-ranging, from inflating revenues before an acquisition to insider trading to failing to disclose bad news, as in Apollo's case. Defendants and industries also vary. Executives in the telecom, biotech, real estate, and education industries have taken the stand, while auditors were the targets in two cases and a commercial bank in another. The size of alleged damages also runs the gamut, from less than $100 million in six cases to more than $18 billion in the JDS case. And in each case, the defendants all made formal and informal efforts to settle.
What most share, however, is a lead plaintiff in the form of an institutional investor, often a pension or benefits fund, looking for a settlement that would stretch the bounds of both propriety and insurance coverage. (Connecticut Retirement Plans and Trust Funds was the lead plaintiff against JDS Uniphase, for example, while the Policemen's Annuity and Benefit Fund of Chicago led the charge against Apollo.) When institutional investors get involved, the "settlements are much higher and they're fully willing to take these cases to trial," says Blair Nicholas, a partner with Bernstein Litowitz Berger & Grossmann who represented hedge fund Otter Creek Partners in a 2005 trial against Clarent Corp. It's a trend Nicholas and others predict will only continue. According to Cornerstone, half of the plaintiffs in cases that settled in 2006 were institutional investors, up from 20 percent in 2004.
When institutional investors run up against executives who believe they are firmly in the right, conditions are ripe for a trial. In Apollo's case, the insurers "were perfectly willing to settle, and probably would have preferred that we settle," says Smith. But those executives dropped settlement discussions after one mediation session because "they felt they were right." (Gonzales declined to be interviewed for this story.) One reason the company was so adamant was that it had consulted widely about its decision not to disclose the report. "If you're not safe to make disclosure decisions based on the advice of professionals, it's hard to know when you'll be safe," says Smith. Those same factors led former executives at Thane International, Everex, BDO Seidman, and Biogen to the stand in past trials.
The financial motives behind going to trial, however, can cut both ways. Typically, executives in these trials share something of a gambler's spirit — and like the odds that a jury won't assess the full amount of damages. "We had the sense that even if they [BDO Seidman] didn't completely get off the hook, they would be assigned a smaller portion of blame" than they would face otherwise, says Michael Young, partner at Willkie Farr & Gallagher LLP and lead attorney for the audit firm in its 1998 trial. BDO Seidman was exonerated. On the other hand, sometimes it is fiscally prudent to fight. JDS Uniphase "had no alternative" but to head to court, says attorney Eth, since both the damages and the shareholders' proposed settlement values were beyond any insurance coverage or cash stash the company had.
The X Factors
Of course, once the decision is made, companies are subject to the same whims and uncertainties of any other trial. To date, 8 out of 13 trials that have reached a verdict have been in favor of the defense, says Savett. But as the JDS Uniphase and Apollo cases illustrate, there are plenty of X factors at work.
To identify them, lawyers often use mock juries to test their cases. Such panels are paid to listen to a case and arrive at a verdict. While a negative outcome might not kill the case, it will certainly inspire some changes. "Mock juries don't necessarily turn out the same way as actual juries do, but you can learn a lot from them about what they think are good facts and what they think are bad facts," says Young.
In addition, attorneys say they also make honest assessments about how well defendants will play before a jury. While it may not be possible to avoid putting an arrogant or acerbic executive on the stand, you can "practice a lot to try to make them more appealing and take the edge off," says Robert Varian, a partner with Orrick, Herrington & Sutcliffe. "Then, to the extent possible, minimize their role in the case." The evidence that comes up during discovery is also part of the calculation. "Is there one really, really bad memo or E-mail out there?" asks Reed Smith partner Sarah Wolff. If so, executives and attorneys must recalculate their odds at trial, and possibly reconsider the settlement option.
That option weighs heavy over every decision to go to trial. And it's a complex trade-off, thanks to directors'-and-officers' (D&O) insurance. "If you are facing damages that go way beyond the coverage limits, and you can settle it for a modest amount with some contribution from the carrier," settling is almost a no-brainer, says Wolff. If a company goes to trial and wins, though, it can save the cost of a settlement, likely in the billions for JDS Uniphase. Legal fees are no doubt higher, but D&O insurance covers those in almost all cases. That makes a successful trial "free" in a certain sense, not counting sizable time and effort on the part of companies and executives.
Losing, of course, makes things considerably worse. A company faces both the cost of damages, which may or may not be more than a settlement would have run, and the risk of losing its insurance coverage. "If you have a final finding of intentional wrongdoing, that would remove the coverage," leaving the firm on the hook for both damages and legal costs, says Michael Tu, an attorney at Orrick who successfully represented defendants in a 2005 case against Thane International. It's not yet clear what will happen with Apollo, but the firm disclosed in late January that it had racked up $25 million in costs related to the trial, including legal fees, and that its insurers still had the right to withdraw coverage.
Costly, in More Ways Than One
Given their druthers, some D&O providers would like to see more companies take a hard line against shareholders. "Many securities and derivatives cases are nonsense, or at least very weak, and when they result in significant payments to resolve them, the effect is to chum the water," says John Lenzen, worldwide head of litigation for ACE Group of Cos. "It's a shame."
Considering the exposure involved and the fact that insurance often covers settlements, it's still unlikely that such cases will become de rigueur, though. For one, the recent trials give just as much impetus to big shareholder plaintiffs as to companies to stand their ground. The fact that companies more often win does change the calculus, "but it still doesn't mean there will be lots going to trial," says Varian.
As for life after a trial, it does go on. Kenda Gonzales, for example, is working for a private real estate company, according to her court testimony. Anthony Muller says he is "loving" his retirement in Pebble Beach, California. Others have made lemonade out of lemons. Former Clarent CFO Simon Wong (who never went to trial, because the charges against him personally were dismissed) is now consulting with other companies on Section 404 of Sarbanes-Oxley, according to his attorney, Orrick's William Alderman.
But would any CFO who has been through such a trial recommend it to others? Unlikely, say attorneys. Win or lose, each trial required months of preparation, weeks of sitting in the courtroom listening to past events being rehashed in excruciating detail, and days of enduring hostile questioning on the stand. Then there's the long, drawn-out appeals process, which can last years after the verdict is rendered. "This case, even as a victory, took a toll on the defendants," says Eth. "People often forget that."
Alix Stuart is a senior writer at CFO.
To see a chart showing how other securities lawsuits have played out, click here.
JDS Uniphase vs. Connecticut Retirement Plans
Allegations: Institutional investor Connecticut Retirement Plans and Trust Funds charged that JDS Uniphase executives hid knowledge of the company's impending collapse in 2001.
Damages Sought: More than $18 billion
1. CFO Anthony Muller was grilled by plaintiffs' attorneys about how he managed inventory and his relationship with auditors. His sale of $35 million in stock was also questioned.
2. Former JDS Uniphase CEO and cofounder Jozef Straus insisted on the witness stand that his 2001 revenue projections were "not pie in the sky."
3. Company attorney Jordan Eth, a partner with Morrison & Foerster, credits the credibility of the executives for the eventual positive outcome for JDS Uniphase.
Date of Verdict: November 2007
Outcome: Jury found the company not guilty; no damages awarded.
Apollo Group vs. Policemen's Annuity
Allegations: Institutional investor Policemen's Annuity and Benefit Fund of Chicago charged that Apollo Group did not disclose regulatory problems in a timely manner.
Damages Sought: $5.55/share
1. Apollo Group, parent of the University of Phoenix, found itself in trouble with shareholders when it decided not to reveal a preliminary report from the Department of Education that ultimately led to a $9.8 million settlement.
2. CFO Kenda Gonzales spent hours on the witness stand rehashing a single meeting with the DoE in 2003 and defended the decision not to disclose the report.
3. Company attorney Wayne W. Smith, a partner with Gibson, Dunn & Crutcher, believes the jury took an individual-investor view rather than an institutional-investor view in deciding against the company.
Date of Verdict: January 2008
Outcome: Jury found the firm liable for $5.55 per share. Case could ultimately cost $270 million.
Is There a Target on Your Back?
What makes a company vulnerable to a class-action securities lawsuit in the first place? An analysis of last year's suits shows that companies in certain industries — financial services, technology, and life sciences — are more likely than others to get hit, according to insurance broker Carpenter Moore.
Across industries, however, CEO compensation is a leading indicator of a company's vulnerability, according to The Corporate Library's analysis of four years' worth of data. What is it exactly that triggers a lawsuit? Paul Hodgson, senior research associate for the shareholder advocacy group, says "it's the extremes that would probably be the most risky, the all-cash or all-stock kind of approach." Such simplistic packages may make it easier to cheat, he speculates, while more complex packages make cheating "too complicated to be worthwhile" — or at least too complicated for shareholders to build a case around.
Lack of board independence and a high degree of institutional ownership were the other two key factors in predicting a securities class-action, according to The Corporate Library's report. However, both together exerted about the same degree of influence as compensation issues alone.
For better or worse, CFO pay is unlikely to have the same predictive value as CEO pay, says Hodgson. While CFOs may face the same "perverse incentives that cause suits," he says, "it's just not at the same level." — A.S.