Electrolyser development at HELION/AREVA Status & Perspectives

First Quarter 2007

Securities Litigation and Professional Liability Practice

Newsletter

Issue No. 15

Since the Supreme Court put an end to “aiding and abetting” liability as a basis for private securities fraud claims under Section 10(b) of the Securities Exchange Act of 1934 in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 180 (1994), it has been black-letter law that defendants may bear responsibility in a private action under the securities laws only for their own statements and omissions. Nonetheless, the application of this principle to so-called secondary actors such as auditors, lawyers and underwriters – those frequently tasked as “gatekeepers” to monitor the flow of accurate information from issuers to the investing public – has been less than clear.

A pair of recent decisions by the US Court of Appeals for the Second Circuit both reaffirms this principle and examines its limits. In Lattanzio v. Deloitte & Touche LLP, No. 05-5805-cv, 2007 WL 259877, at *7 (2d Cir. Jan. 31, 2007), the Second Circuit held that an auditor may not be liable under Section 10(b) for helping to compile and reviewing (but not auditing) its client’s

interim financial statements included in Form 10-Qs, when the issuer attributed no statement made in the Form 10-Qs to the auditor.

In Overton v. Todman & Co., No. 06-2496-cv, 2007 WL 574623, at *8-9 (2d Cir. Feb. 26, 2007), the Second Circuit held “that an accountant has a duty to correct its prior certified statements,” but not “a broader duty to update those statements.” Taken together, the decisions draw important lines regarding the extent to which auditors, and perhaps other secondary actors, may face primary liability for securities fraud.

Defendants are Not Responsible for Statements Made by OthersThe holding in Lattanzio – that if no statements in an issuer’s Form 10-Q are attributed expressly to its auditor, then no alleged misstatements in those documents may be attributed to the auditor – did not create new law. But the decision provided much-needed reaffirmation and clarification of Second

Inside This Issue:

Statements Made and Not Made: An Auditor’s Duty to Correct, and the Scope of Liability for Statements Made by Others

1

Director Liability for Failure of Oversight

5

Collateralized Debt Obligations: Managing Conflicts, Liability and Risk

8

Recent Delaware Decisions Focus on Decisionmakers’ and Advisors’ Incentives and Reject Bright-Line Rules in M&A Deals

11

Circuit and State Round-Up

15

Out In Front: Recent and Upcoming Seminars and Speaking Engagements

19

Recent Wins 20

Statements Made and Not Made: An Auditor’s Duty to Correct, and the Scope of Liability for Statements Made by OthersBy Jeff G. Hammel and Robert J. Malionek

Securities Litigation and Professional Liability Practice, First Quarter 20072

Circuit precedent. The Second Circuit long has held that “if an accountant does not issue a public opinion about a company, although it may have conducted internal audits or reviews for portions of the company, the accountant cannot subsequently be held responsible for the company’s public statements issued. Shapiro v. Cantor, 123 F.3d 717, 721 (2d Cir. 1997); see also Wright v. Ernst & Young, L.L.P., 152 F.3d 169, 175 (2d Cir. 1998) (“a secondary actor cannot incur primary liability under the [Exchange] Act for a statement not attributed to that actor at the time of its dissemination”). Consistent with Central Bank, the law in the Second Circuit is that a secondary actor’s mere assistance in another’s statement is insufficient to impose liability in a private action under Section 10(b), because the plaintiff could not rely – without some additional duty of the secondary actor to speak – upon such unstated assistance. See Wright, 152 F.3d at 175.

The plaintiffs in Lattanzio argued that they and all investors know full well that auditors are required by SEC regulations to “review” interim financial statements reported in Form 10-Qs, see 17 C.F.R. § 210.10-01(d), and thus auditors are liable under Section 10(b) for keeping quiet in the face of known misstatements they allegedly are bound to correct. The Second Circuit followed Shapiro and Wright by rejecting this “behind-the-scenes” argument: “Unless the public’s understanding is based on the accountant’s articulated statement, the source for that understanding – whether it be a regulation, an accounting practice, or something else – does not matter.” The review requirement, in other words, creates no duty by the auditors to correct the statements made solely by the company.

The implications of the Lattanzio decision are far-reaching. The court reined in recent limitations on its prior precedent imposed

by some district courts within the Second Circuit, in decisions which have extended primary liability for private Section 10(b) claims to secondary actors to whom no statement was attributed at all. See, e.g., In re Global Crossing Ltd. Sec. Litig., 322 F. Supp. 2d 319, 333 (S.D.N.Y. 2004) (holding that if a defendant’s alleged role in another’s misstatement is “substantial enough that s/he may be deemed to have made the statement, and where investors are sufficiently aware of defendant’s participation that they may be found to have relied on it,” this may be sufficient to state a claim); In re Van Der Moolen Holding N.V. Sec. Litig., 405 F. Supp. 2d 388, 402 (S.D.N.Y. 2005) (holding that a subsidiary may be primarily liable for statements made by its parent, where the statements clearly identified the subsidiary as the source of the information disclosed, even though the subsidiary in no way participated in drafting or disseminating the statements).

These district court decisions were based, in large part, on an interpretation of one line in a Second Circuit decision issued after Shapiro and Wright. In In re Scholastic Corp. Sec. Litig., 252 F.3d 63, 75-76 (2d Cir. 2001), the Second Circuit held that an officer could be primarily liable in a private action under Section 10(b) for his or her company’s allegedly-false statements. Focusing on Scholastic’s statement that the officer “was involved in the drafting, producing, reviewing and/or disseminating of” the statements, some district courts, including the court in Global Crossing, interpreted this as a “relaxation” of the Second Circuit’s earlier “absolute” rule against primary liability for statements not actually made by a defendant. Scholastic, however, did not cite to either Shapiro or Wright, thus it is difficult to interpret it as overruling this precedent. That is especially true in light of Scholastic’s further focus on the allegation that the officer exerted “control” over the very company

Robert J. Malionek

Jeff G. Hammel

Statements Made and Not Made: An Auditor’s Duty to Correct, and the Scope of Liability for Statements Made by Others01

Securities Litigation and Professional Liability Practice, First Quarter 2007�

statements alleged to be false – which could be regarded as tantamount to the insider making the statements himself.1

Lattanzio clarified any doubts regarding the rule in the Second Circuit, and implicitly rejected the rationales underlying the district court decisions expanding the rule, by stating that “Wright declined to adopt a ‘substantial participation’ test for liability under § 10(b), instead holding that a party can incur liability only if a misstatement is attributed to it at the time of the dissemination... Wright declined to impose accountant liability under § 10(b) notwithstanding public awareness of an accountant’s review of its client’s statements.” This rule is consistent with Section 10(b) itself, which imposes liability only where a defendant “made” a material misstatement or omission. Other circuits have taken similar positions.2

Thus, an issuer bears responsibility for its own statement, but a secondary actor – even if assisting the issuer and reviewing the issuer’s statement – may not be, under Second Circuit law, primarily liable for that statement.

The Duty to CorrectOne of the longest-established principles of securities law in the Second Circuit never to rise above dicta, an auditor’s “duty to correct” was squarely adopted in Overton, though in limited circumstances. In ITT v. Cornfeld, 619 F.2d 909, 927 (2d Cir. 1980), the Second Circuit stated that “[a]ccountants do have a duty to take reasonable steps to correct misstatements they have discovered in previous financial statements [for which the accountants provided an audit opinion] on which they know the public is relying,” but because the plaintiffs only had alleged aiding and abetting liability against the auditor, this statement was not part of the court’s holding. This principle has been oft-repeated, but never held, by the Second Circuit. See Shapiro, 123 F.3d at 721

(recognizing that a “duty to disclose,” or correct, arises because of a fiduciary duty or relation of trust, and stating – though only in dicta, because the plaintiff did not plead this theory – that such a special relationship with the investing public is created when an accountant issues an audit opinion);3 Wright, 152 F.3d at 177 (agreeing that an auditor could face primary liability for learning facts undermining its audit opinion, knowing the market was relying upon the opinion, and failing to correct it, but not holding so because the plaintiff raised this theory for the first time on appeal). Again in Lattanzio, the Second Circuit “assumed” such a duty with respect to an auditor’s annual audit opinion, but affirmed the dismissal of claims based on those statements on other grounds.4

In Overton, the plaintiff alleged that a company’s auditor knew its opinion regarding a company’s past financial statements was materially wrong, and knew the company was courting investors such as plaintiff, but failed to issue “any kind of directive or instruction to [the company] not to disclose the financial statements.” The Second Circuit held that this sufficiently alleged a misrepresentation by the auditor. Specifically, an auditor faces primary liability when it:

(1) makes a statement in its certified opinion that is false or misleading when made; (2) subsequently learns or was reckless in not learning that the earlier statement was false or misleading; (3) knows or should know that potential investors are relying on the opinion and financial statements; yet (4) fails to take reasonable steps to correct or withdraw its opinion and/or the financial statements; and (5) all the other requirements for liability are satisfied.

The Second Circuit was quick to set limits around this theory of liability. First, its holding that a duty to correct exists was, as it should be, expressly limited to “the

01 Statements Made and Not Made: An Auditor’s Duty to Correct, and the Scope of Liability for Statements Made by Others


circumstances as pled in the securities claim now before us,” and the court emphasized that it had “no occasion to answer whether the duty to correct might arise in other circumstances.” The extent to which the duty may apply to other secondary actors thus remains an open question.

Second, an auditor’s duty to correct is not a duty to update: “The duty to correct requires only that the accountant correct statements that were false when made,” whereas the duty to update requires altering a statement, accurate when made, but subsequently made misleading by intervening events. Auditors have no such duty to update.

Third, following on the heels of Lattanzio, the auditor’s duty to correct applies only to its own statements, e.g., audit opinions and consents, and not to the statements of others (such as a company’s press releases or interim financial statements in Form 10-Qs reviewed by the auditor). Nor does the auditor have a duty “to divulge information collateral to the statements of accuracy and financial fact set forth in its opinion and the certified financial statements, respectively.”

Thus, under Lattanzio, when an auditor makes a statement to the investing public about an issuer’s financial statements, it takes on a duty to correct that statement, as well.

ConclusionWith the guidance provided by these two recent opinions, the Second Circuit has assured secondary actors – or at least auditors – that, to the extent they are “gatekeepers” for the investing public, they serve that role only with respect to their own statements. n

(Endnotes)1 This is not to be confused with control person liability

under Section 20(a) of the Exchange Act. See S.E.C. v. First Jersey Securities, Inc., 101 F.3d 1450 (2d Cir. 1996).

2 See, e.g., Anixter v. Home-Stake Prod. Co., 77 F.3d 1215, 1226 (10th Cir. 1996); In re Rent-Way Sec. Litig., 209 F. Supp. 2d 493, 502-03 (W.D. Pa. 2002) (dismissing claim against auditor based upon its client’s Form 10-Qs, which contained “no misrepresentations attributable to” the auditor “upon which investors could have relied”); In re Kendall Square Research Corp. Sec. Litig., 868 F. Supp. 26, 28 (D. Mass. 1994) (auditor’s review and approval of company documents insufficient to state a Section 10(b) claim against auditor); see also Zoelsch v. Arthur Andersen & Co., 824 F.2d 27, 35 (D.C. Cir. 1987) (auditor not liable where it made no statements alleged to “reach investors”). But see In re Software Toolworks Sec. Litig., 50 F.3d 615, 628 n.3 (9th Cir. 1995) (accountants may be liable for company’s letter where they played “significant role” in drafting the letter); In re Polaroid Corp. Sec. Litig., 134 F. Supp. 2d 176, 184 (D. Mass. 2001) (stating First Circuit law “assume[s]” that a company may be liable for an analyst’s statement where the company has “adopted, endorsed or sufficiently entangled itself with the analyst’s reports”); Cashman v. Coopers & Lybrand, 877 F. Supp. 425, 434 (N.D. Ill. 1995) (accountant’s “central involvement” in preparation of company’s materials sufficient to state a claim against accountant).

3 Shapiro held further that a duty to speak arises for an accountant who “exchanges his or her role for a role as an insider who vends the company’s securities.” 123 F.3d at 721.

4 In Lattanzio, the plaintiffs argued that the auditor’s opinion in a Form 10-K issued before the class period contained two material misstatements and that the auditor learned of one misstatement before the class period and another misstatement during the class period. The plaintiffs argued that the auditor had a duty to correct the misstatements. The Second Circuit – assuming a duty to correct existed – dismissed the claim based on the misstatement discovered by the auditor before the class period because “[a] defendant is . . . liable only for those statements made during the class period.” In re IBM Sec. Litig., 163 F.3d 102, 106 (2d Cir. 1998). The court dismissed the claim regarding the other misstatement because the plaintiffs failed to plead loss causation adequately.

Statements Made and Not Made: An Auditor’s Duty to Correct, and the Scope of Liability for Statements Made by Others01


The personal liability exposure of public company directors has been a vibrant subject of debate and speculation as one high-profile development after another has put the spotlight on board oversight – from the Sarbanes-Oxley Act, to the Disney-Ovitz saga, to out-of-pocket director settlements in Enron and Worldcom, to the stock options backdating scandal. A recent Delaware Supreme Court decision has now confirmed the legal framework governing director liability for failure to oversee corporate conduct adequately.

In Stone v. Ritter, 911 A.2d 362 (Del. 2006), the Court expressly adopted the 10-year-old Caremark1 standard for determining whether directors have breached their fiduciary duty to oversee the corporation and its operations and monitor compliance with applicable laws and regulations. In an important doctrinal shift, however, the Court held that conduct which is sufficiently egregious to establish liability for failure of oversight under Caremark necessarily constitutes lack of good faith and a breach of the fiduciary duty of loyalty. Such conduct, under Delaware law, may result in personal monetary liability that can neither be exculpated nor indemnified by the corporation.

The Stone decision also resolved a long standing academic debate by clarifying that there is no independent fiduciary duty of good faith. Rather, conduct that is not in good faith is a breach of the fiduciary duty of loyalty, even if the conduct does not involve any self-dealing or other conflict of interest.

Factual Background of StoneStone v. Ritter involved AmSouth Bancorporation’s wholly-owned subsidiary, AmSouth Bank, which operated numerous commercial banking branches throughout the southeastern United States. Upon discovery that third parties were operating a Ponzi scheme through AmSouth’s banks, various governmental and regulatory bodies investigated AmSouth’s compliance with provisions of the Bank Secrecy Act and other anti-money-laundering laws. Those organizations concluded that even though AmSouth employees believed that suspicious activities were occurring, AmSouth had failed to file the “Suspicious Activity Reports” (SAR) required by law.

Fines and civil penalties totaling $50 million were ultimately assessed against AmSouth on the basis of determinations that AmSouth’s SAR compliance programs lacked adequate board and management oversight. As part of those investigations, AmSouth was also ordered to engage an independent consultant to review its compliance procedures.

KPMG conducted that review and found that the directors had adequately discharged their responsibility to establish an information and reporting system, and that the system was properly designed to permit the directors to periodically monitor AmSouth’s compliance with the applicable laws and regulations.

AmSouth shareholders nevertheless brought a derivative action against AmSouth’s directors, alleging that they breached their fiduciary duties by failing to establish an appropriate set of internal controls that would have exposed any improprieties.

Director Liability for Failure of OversightBy Pamela S. Palmer and Andrew M. Farthing

02

Andrew M. Farthing

Pamela S. Palmer


The Delaware Supreme Court Adopts the Caremark StandardIn affirming the dismissal of the complaint, the Supreme Court adopted the Caremark standard articulated by former Chancellor Allen that director oversight liability exists when: “(a) the directors utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system or controls, directors have consciously failed to monitor or oversee its operations, thus disabling themselves from being informed of risks or problems requiring their attention.”

For 10 years, the Court of Chancery had construed Caremark as requiring plaintiffs to plead an egregious lack of oversight in order to state a claim. The Court considered a failure of oversight claim to be “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” To date, no Delaware court has ever found a breach of the duty of oversight, and only one such claim has survived a motion to dismiss.2

The Delaware Supreme Court’s adoption of this standard, together with the affirmance of the dismissal in Stone, further establishes the extreme difficulty facing a shareholder plaintiff to marshal sufficient facts to survive a motion to dismiss. In Stone, for example, even a determination by a federal regulatory authority that AmSouth’s monitoring and compliance programs “lacked adequate board and management oversight, and that reporting to management for the purposes of monitoring and oversight of compliance activities was materially deficient” was insufficient to state an oversight claim.

A Failure to Exercise Oversight Can Be a Breach of a Director’s Duty of LoyaltyDespite this high standard for liability, however, the decision in Stone v. Ritter has potentially serious ramifications for the defendant directors when such a claim does survive a motion to dismiss, namely the possible unavailability of indemnity protection if such claims are proved. As originally conceived in the Caremark decision, failure to provide adequate oversight was a breach of the fiduciary duty of care (a failure to be adequately informed), and Delaware law permits companies to provide exculpation to their directors from any monetary liability arising from a violation of the duty of care pursuant to its certificate of incorporation. The vast majority of Delaware corporations have adopted such provisions shielding directors from monetary liability to the maximum extent permitted under 8 Del. C. § 102(b)(7) – that is, limiting liability to breach of the duty of loyalty, and to acts that are not taken in good faith or that involve intentional misconduct.

Yet the Court of Chancery began to question whether the egregious conduct necessary to prove a Caremark claim could be exculpable, given that a plaintiff would have to prove conduct beyond gross negligence that constituted a “sustained or systematic failure to exercise oversight.” In 2003, the decision in Guttman v. Huang noted that although the duty to monitor as articulated in Caremark is based in the duty of care, Caremark “articulates a standard for liability for failures of oversight that requires a showing that the directors breached their duty of loyalty by failing to attend to their duties in good faith.”3 Such a failure to act in good faith would be neither exculpable

Director Liability for Failure of Oversight02


pursuant to 8 Del. C. § 102(b)(7), nor subject to indemnity pursuant to 8 Del. C. § 145, thus potentially opening up the directors to non-exculpable personal liability, even if the director did not possess a personal financial interest in the transaction.

Just weeks after the Guttman decision was issued, the Court of Chancery reiterated this view in the widely followed In re The Walt Disney Co. Derivative Litigation, in a decision denying the directors’ motion to dismiss.4 The Disney decision held that the plaintiffs had stated a non-exculpable claim for breach of fiduciary duty by alleging that the Disney directors “consciously and intentionally disregarded their responsibilities.” The court concluded that this “knowing or deliberate indifference by a director to his or her duty to act faithfully and with appropriate care is conduct, in my opinion, that may not have been taken honestly and in good faith to advance the best interests of the company.”

The Disney directors eventually prevailed at trial in a decision that was affirmed by the Delaware Supreme Court in the summer of 2006.5 In that decision, the Delaware Supreme Court declined to address the issue of whether a failure to act in good faith could serve as a ground for director liability, independent of the breach of the duty of care or loyalty.

In Stone, the Delaware Supreme Court resolved this issue, holding that a failure to act in good faith would be a “necessary condition” to liability. Liability, however, would be based on a breach of the fiduciary duty of loyalty, as “the obligation to act in good faith does not establish an independent fiduciary duty,” but rather is a “subsidiary element” of the duty of loyalty, even when the director’s financial self-interest was not implicated by the underlying conduct. In so holding, the Delaware Supreme Court shepherded a transformation of a

claim for failure of oversight from a breach of the duty of care as originally discussed in Caremark, to a breach of the duty of loyalty for which corporate financial exculpation may not be available.

What this Means for DirectorsThe practical implications of this doctrinal shift have yet to evolve; most Delaware corporations, however, undoubtedly will continue to advance costs of defense to their directors in actions for alleged failure of oversight, until and unless the claims are proved. Nonetheless, because a successful claim that directors failed to exercise appropriate oversight would be neither exculpable nor subject to indemnity under Delaware law, directors may find themselves looking to “Side A” directors and officers insurance coverage to protect them from out-of-pocket liability.6

In sum, boards of directors should carefully consider their potential exposure and insurance needs in light of Stone, but most importantly, directors should regularly ensure that appropriate internal controls are in place and functioning properly to minimize the risk of any imposition of liability. n

(Endnotes)1 In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959 (Del.

Ch. 1996).2 In Saito v. McCall, 2004 Del. Ch. LEXIS 205 (Dec. 20,

2004), Chancellor Chandler, who was also the trial judge in Stone, concluded that the amended Caremark claim in that case “barely” survived a motion to dismiss. Chancellor Chandler had previously dismissed the oversight claim without prejudice, after which plaintiffs sought books and records pursuant to 8 Del. C. § 220 in order to obtain the additional facts presented in the amended complaint.

3 823 A.2d 492, 506 (Del. Ch. 2003).4 825 A.2d 275 (Del. Ch. 2003).5 In re The Walt Disney Co. Deriv. Litig., 907 A.2d 693

(Del. Ch. 2005), aff’d 906 A.2d 27 (Del. 2006).6 “Side A” coverage protects directors and officers against

claims for which the directors and officers cannot be indemnified by the corporation.

Director Liability for Failure of Oversight02


Collateralized debt obligations (CDOs) have become increasingly popular globally in recent years with total issuance figures increasing substantially year-upon-year, and that popularity is expected to grow with the market seeing greater sophistication in structure and complexity. There are few English court decisions available to interpret the legal duties and liabilities arising from CDO. Here, we examine one recent case highlighting to some extent these issues, and offer some initial ideas on ways to navigate any potential pitfalls.

CDO Basics CDOs – securities backed by pools of assets such as loans, bonds and other asset-backed securities – are designed to offer investors a tailored risk/return profile by allowing investors to purchase securities issued by the CDO issuer, which are “tranched” so that certain securities bear defaults in the underlying assets prior to other securities issued by the same CDO issuer. The various securities are then priced according to the risk of default. CDOs can either be cash CDOs, where the CDO issuer actually owns the assets involved, or synthetic CDOs, where the issuer acquires exposure to the assets through a credit derivative transaction. An example of the latter is a credit default swap in which the CDO issuer is the credit protection seller. Most CDOs are governed by English or New York law.

The typical CDO structure involves participation from a variety of entities including – in addition to investors – an arranger, a collateral (or portfolio) manager,

and a “special purpose vehicle” (SPV) to hold the collateral and issue the securities to be purchased by investors. The arranger establishes the SPV/issuer, while the collateral manager manages the collateral pursuant to an agreement that sets out its responsibilities and liabilities with respect to the selection and management of the collateral. Issues can potentially arise over the structure of a CDO, the way in which the CDO is marketed and sold, and the management of the collateral in a CDO, specifically when substitutions are made to the collateral.

The Barclays Corvus Litigation Although most English cases involving CDOs have settled, leading to a dearth in court decisions on CDO specific issues, one of the most high-profile cases to date was brought by HSH Nordbank against Barclays Bank in the Commercial Court in London and highlights the risks and controversies that can arise from a typical CDO. The case arose from a $151 million investment in 2000 by HSH Nordbank (or LB Kiel as it was then) in Corvus Investments Limited (Corvus), an actively managed synthetic CDO arranged and marketed by Barclays Capital (Barclays). Part of a series of 16 managed CDOs arranged by Barclays between 2000 and 2002 with a total issue volume of approximately $15 billion, Corvus referenced 150 asset-backed securities, CDOs and credit derivatives. Barclays was both the arranger and collateral manager on the deal, so was responsible for choosing which credits to buy and sell from the pool during the transaction’s lifetime.

Collateralized Debt Obligations: Managing Conflicts, Liability and RiskBy Mark Nicolaides, Basil Zotiades and Jumana Rahman

0�

Mark Nicolaides

Basil Zotiades

Jumana Rahman


Corvus’s credit quality deteriorated rapidly from 2001, largely because it had holdings in a number of underperforming sectors such as aircraft securitizations and other CDOs. Between December 2002 and September 2003, Fitch (the only agency that rated the entity’s offerings) downgraded Corvus’ senior tranches from AAA to BB and its lowest-rated tranche from B to C. HSH Nordbank had invested in tranches that were all above investment grade and had scheduled maturities of 8-12 years, with legal maturity in 2030. By the end of 2003, when it is believed that a large part of the original collateral had been substituted, HSH Nordbank’s investment was alleged to be essentially worthless.

In July 2003, HSH Nordbank sued Barclays for $151 million, the amount it had invested in the CDO. HSH Nordbank brought three principal claims against Barclays arising out of the transaction. First, HSH Nordbank alleged that Barclays had mis-sold the CDO to its predecessor, LB Kiel, and had not adequately explained the risks relating to the products.

Second, HSH Nordbank alleged breaches of duty in the management by Barclays of the portfolio of assets underlying the notes purchased by HSH Nordbank, and that Barclays had used its power as collateral manager to benefit its own balance sheet rather than the deal. Chief among its complaints was that Corvus had exposure to subordinated tranches of several other (interlocking) CDO transactions on which Barclays was both collateral manager and arranger – this cross-referencing helped create a domino effect, as downgrades of one CDO triggered downgrades of another. HSH Nordbank further claimed mismanagement because Barclays had substituted poorly performing assets into the CDO, including telecoms bonds, emerging market debt and aircraft lease securities after the events on September 11, 2001. HSH Nordbank claimed that the decline in the

value of the derivatives was the result of this mismanagement.

Third, HSH Nordbank claimed Barclays had provided inaccurate pricing information. HSH Nordbank alleged that Barclays had overvalued assets in the CDO’s portfolio in its post-closing investor reports, thereby concealing the extent of the losses.

Conflicts Underlying the CDO Structure Though the case settled shortly before trial, the case was significant as the first to raise important issues of liability and duties in the CDO context. While the case did not formally raise conflict of interest issues, there was clearly a dispute over what HSH Nordbank and Barclays believed the duties of the collateral manager to be. This dispute was exacerbated by the fact that Barclays played a number of different roles in the structure. As discussed above, there are a number of roles involved in the formation and management of a CDO, many of which often are performed by the same entity. For example, a bank can arrange the transaction, conduct the investment management of the collateral, and also, in a synthetic structure, act as swap counterparty.

In light of this, we set out below a number of different CDO structures, with differing risks. One structure is a static CDO, in which the collateral is fixed throughout the life of the CDO. As the collateral content of the CDO is fixed and disclosed to investors at the outset, the collateral manage faces the fewest ongoing legal risks related to investment decisions.

A second structure is a CDO where both the investors and the collateral manager must agree to any substitution of collateral for that substitution to take place. This structure is occasionally seen in smaller transactions placed with a single investor

Collateralized Debt Obligations: Managing Conflicts, Liability and Risk0�


or a small group of investors. This operates by way of investors suggesting substitutions in the collateral, in response to which the collateral manager sets the proposed pricing changes, whereupon the investors and the collateral manager agree whether to implement the substitutions. It is essentially a static CDO, unless there is mutual consent to substitution. This type of structure reduces the risks, as the decisions are mutually taken, but it may not be completely devoid of risk as, from a legal risk management perspective, the real issue is not so much who initiates (or consents to) substitutions but in what capacity, and in the context of what relationship, that party does so.

A third structure, perhaps the most typical, is that of a managed CDO. This is the most common CDO structure to be found in the marketplace, but is also the structure that holds the most residual ongoing risks. This is particularly the case with the (now very rare) variant of this structure where, as in the Barclays CDO, the arranging bank and swap counterparty also retains the right to effect substitutions in the portfolio.

Reducing the Conflict of Interest Risk These risks should be carefully considered and can be addressed through planning. As seen above, one entity, for example a bank, can take on multiple roles in a CDO. As arranger of the transaction, the bank’s primary motivation will be to market successfully the notes issued by the CDO. As collateral manager, the bank will be contractually obliged to the issuer (and often also, at least in certain circumstances, to the Trustee of the Noteholders) to manage the collateral with reasonable care and judgment, in a manner consistent with the practices and procedures generally followed by institutional asset managers. However, the collateral manager will not generally have a

contractual relationship with the Noteholders obliging it to act in their best interests, which can lead to difficulties in terms of investor perception. In a synthetic CDO, added to these roles and responsibilities could be a role for the bank as the swap counterparty. Given the different motivations and objectives for each role, difficulties can arise.

A first step to mitigate this concern is to structure the parties’ roles and legal relationships with one another so as to reduce the scope of legal recourse against the party whose interests one seeks to protect. In this regard, in addition to contractual nexus, the capacity in which a party performs its role is a central consideration.

The second step is to ensure that the contractual obligations of each party are suitably crafted so as to seek to eliminate, if possible, or at least reduce, the impact of duties implied by law (including clarifying the existence, or not, of any fiduciary obligations). There may also be issues over potential tort claims, but discussion of these are outside the scope of this article.

Having done this, it is important to ensure full disclosure to investors of all roles undertaken by the parties, the capacities in which roles are undertaken and the conflicts involved. Pre-marketing and marketing activities should also convey a message that is consistent with the approach adopted on the structuring of the legal relationships as disclosed in the offering circular.

Many other issues regarding potential conflicts of interest need to be carefully considered, preferably at the outset and in conjunction with key decisions about the structuring and marketing of the transactions, to ensure that any potential exposure is minimized. n

Collateralized Debt Obligations: Managing Conflicts, Liability and Risk0�


Two recent Delaware Court of Chancery decisions suggest a major shift in the way in which courts review merger transactions. In the litigation over the proposed merger between Caremark and CVS, Chancellor Chandler delayed the Caremark shareholders’ vote to allow for additional disclosures regarding investment banker compensation and appraisal rights.1 Separately, Vice Chancellor Strine postponed the vote of Netsmart Technologies’ shareholders pending additional disclosure of management projections and the rationale for pursuing only transactions with private equity.2

In each of these decisions, the Court showed increasing skepticism toward the incentives of directors, officers and investment bankers. In addition to putting decisionmakers’ incentives under more intense scrutiny, these decisions underscore the risk of reliance on the conventional wisdom of bright-line rules when structuring and negotiating deals involving Delaware corporations. Below, we discuss these recent cases and provide pointers for reducing litigation risks and increasing the likelihood of timely closing future transactions.

CaremarkOn November 1, 2006, Caremark and CVS announced a definitive agreement to combine the two companies. The terms of the proposed transaction, primarily a stock deal, provided for a “special dividend” from Caremark to its shareholders. The dividend was declared before the vote, but

was payable only if the transaction was consummated. The “merger of equals” transaction was subject to reciprocal $675 million termination fees, just less than 3.0 percent of the transaction value.

Shortly after the merger was announced, a Caremark competitor, which had made a competing offer for Caremark, and large institutional shareholders filed suit in the Delaware Court of Chancery and sought a preliminary injunction to block the merger. The Court granted the motion in part, delaying the Caremark shareholder meeting until 20 days after Caremark provided disclosures about appraisal rights based on the “special dividend” (which the Court found to be merger consideration) as required by statute.3 The Court also required Caremark to make additional disclosures about the fees paid to its financial advisors.

Importantly, the Court rejected defendants’ argument that the termination fee was within a per se acceptable range, notwithstanding numerous Delaware precedents approving breakup fees of 3.0 percent and higher. The Court warned, “Though a ‘3% rule’ for termination fees might be convenient for transaction planners, it is simply too blunt an instrument, too subject to abuse, for this Court to bless as a blanket rule.” Instead, the Court will evaluate the complete package of deal protections “as a whole,” and in the context of the specific transaction and its history to determine whether plaintiffs have met their burden of demonstrating that the deal protections

Recent Delaware Decisions Focus on Decisionmakers’ and Advisors’ Incentives and Reject Bright-Line Rules in M&A DealsBy Terri L. Lilley and Andrew M. Farthing

0�

Terri L. Lilley

Andrew M. Farthing


are preclusive or coercive. Nonetheless, as to the Caremark-CVS merger, the Court determined that the shareholders’ exercise of a fully informed vote would preclude the possibility of irreparable harm, implicitly accepting at least that the deal protections were not “coercive.”

As mentioned above, the Court did, however, find the disclosures of the investment bankers’ compensation misleading and required remedial disclosure. The original disclosure outlined that each of the two investment banks advising Caremark received $1.5 million upon providing an opinion (regardless of the conclusion) of the advisability of the Caremark/CVS transaction, and received an additional $17.5 million if the Caremark/CVS transaction occurred, or if Caremark consummated an alternative transaction within nine months. The Chancellor, however was concerned by the fact that it was not clearly disclosed that the bankers’ right to the additional $17.5 million vested only if the Caremark/CVS transaction was publicly announced prior to the consummation of an alternative transaction.

The Court determined that it would be material to a reasonable shareholder to know that “a significant portion of the bankers’ fees rest[ed] upon initial approval of a particular transaction,” demonstrating a clear concern about investment bankers’ incentives to conclude that the transaction was fair in order to hurdle the threshold contingency of an announcement.4 Where those incentives reward bankers for blessing or favoring a transaction, detailed disclosure of the compensation arrangement is likely to be required. Boards and their advisors should be cognizant of the push towards more fulsome disclosure not only in the course of drafting proxy statements, but also much earlier, when engagement letters and

compensation arrangements are negotiated and agreed upon.

The Court was also greatly concerned about the personal incentives of Caremark’s decisionmakers – its officers and directors – to favor the CVS transaction. First, although not a classic “change-of-control” situation triggering Revlon duties to obtain the maximum value reasonably attainable for Caremark shareholders,5 the merger activated contractual change-of-control payments to Caremark managers, notwithstanding that they would keep their jobs. For example, Caremark’s Chairman/CEO would receive $14 million in accelerated options gains and a $26.4 million “severance” payment, yet would remain Chairman of the combined company. More critically in light of options backdating issues at Caremark, the merger would defeat derivative plaintiffs’ standing in ongoing options backdating lawsuits, and CVS agreed (1) to honor all options grants awarded by Caremark, even if granted in violation of the board’s fiduciary duties and (2) to indemnify all past and present directors to the fullest extent permitted by Caremark’s certificate of incorporation or by law. The Court noted that the latter protection theoretically could permit CVS to indemnify for disloyal or bad-faith acts under contract law, where corporate law would prohibit indemnification by Caremark itself.

Consequently, the Court seemed skeptical that Caremark’s decisionmakers could be expected to advance solely the interests of Caremark’s shareholders. After disclosure of the directors’ and officers’ interests, the Court left the ultimate decision to the fully informed vote of Caremark’s shareholders, which overwhelmingly approved the transaction 21 days after Chancellor Chandler’s opinion.6

Recent Delaware Decisions Focus on Decisionmakers’ and Advisors’ Incentives and Reject Bright-Line Rules in M&A Deals0�


NetsmartNetsmart Technologies is a micro-cap software company providing enterprise software for behavioral health and human services organizations. The company acquired its largest direct competitor in October 2005. After it announced that acquisition, private equity buyers made overtures to Netsmart. Rather than canvassing the market for strategic buyers, Netsmart focused on a potential transaction with private equity investors, based upon discussions at an “informal” board meeting where no minutes were kept. The company’s bankers had “recommended that Netsmart explore both a ‘going private transaction’ and a ‘strategic sale.’” In focusing on a private equity transaction, the board relied on a series of unfruitful, isolated contacts with approximately half a dozen potential strategic buyers over the prior seven years to determine that a strategic buyer was unlikely to materialize.

After deciding to focus on only a private equity deal, the board formed a special committee of independent directors. The special committee ultimately approved a merger agreement with two private equity firms that valued Netsmart at $115 million and included a 3 percent termination fee, together with window shop and fiduciary out provisions. Shareholder plaintiffs moved preliminarily to enjoin the merger, and the Court granted a limited injunction requiring additional disclosures before the scheduled April 5 vote.

As in Caremark, the Court was concerned about the decisionmakers’ incentives in promoting the proposed transaction, and about ensuring that disclosures were adequate for shareholders to cast fully informed votes. Of particular concern was the Court’s perception that management had a strong preference for a private equity deal

in anticipation both of keeping their jobs and of receiving generous retention perks. Particularly, the Court disapproved of:

• Netsmart’s failure to consider, or explore potential strategic buyers in light of its increased size and enhanced market position due to recent acquisitions;

• management’s direction of the private equity auction and due diligence process without adequate leadership by the special committee;

• the board’s decision at an informal meeting (before creating the special committee) to pursue only private equity rather than strategic buyers;

• the special committee’s use of Netsmart’s regular financial advisor, rather than retaining an independent advisor;

• Netsmart’s reliance on a post-signing market check that, in light of the company’s micro-cap position, was unlikely to function effectively; and

• Netsmart’s failure to prepare and approve minutes of any relevant board or special committee meetings until after litigation and discovery had commenced.

Importantly, the Court echoed Caremark when it explained that processes and deal terms approved in prior cases are not per se permissible or sufficient, but depend on an equitable evaluation of the particular circumstances in each case.

The Court held that plaintiffs had shown a probability of success on the merits of their claim that the defendants had breached their Revlon duties, and required more fulsome disclosure about the decision to pursue only a private equity deal, but stopped short of enjoining the transaction where no competing deal was pending.



The Court also required disclosure of financial projections by Netsmart management that were relied upon by the financial advisor in rendering its fairness opinion. Citing its opinion in Pure Resources,7 the Court concluded that when shareholders will be cashed out, information regarding the “financial attractiveness” of the proposed transaction is of great importance – particularly in private equity transactions where management retains an interest in the post-merger entity. Ultimately, the Netsmart shareholders approved the proposed transaction on April 5, 2007.8

In light of Vice Chancellor Strine’s decision, boards engaged in a strategic process should carefully consider pursuing discussions with both strategic and financial acquirers, and should document all actions and discussions in timely, formal minutes. If it is contemplated that management will have a continuing interest in the company after the strategic transaction, the board should create, as early as possible, an independent committee that will take an active role in directing the strategic process. Finally, in cash-out transactions, management projections used by the financial advisors for purposes of providing the fairness opinion should be disclosed in the proxy statement, at least in summary form.

ConclusionThe Delaware Court of Chancery appears to be signaling that it will carefully consider the incentives of decisionmakers and advisors in the context of mergers and acquisitions. Where those incentives seem to be imperfectly aligned with shareholder interests, courts are demanding that

companies provide their shareholders with more detailed disclosures into both the interests of the players involved and in the process employed in deciding to recommend a particular transaction.

When negotiating and structuring deals involving Delaware corporations, it is important to evaluate critically if and how the company’s officers, directors or advisors may be perceived to have interests that are not aligned with promoting the best value for shareholders, and to make full disclosure of those interests. Finally, the board should be prepared to articulate the propriety of deal protections and effectiveness of market checks even where the relevant deal terms appear unobjectionable under existing case law. n

(Endnotes)1 Louisiana Mun. Police Employees’ Ret. Sys. v. Crawford,

2007 WL 582510 (Del. Ch. Feb. 23, 2007).2 In re Netsmart Technologies, Inc. Shareholders

Litigation, 2007 WL 778612 (Del. Ch. Mar. 14, 2007). 3 8 Del. Code § 262.4 See also Ortsman v. Green, 2007 WL 702475 (Del. Ch.

Feb. 28, 2007) (ordering expedited discovery where plaintiffs alleged that bankers discouraged pursuing one strategic buyer because the transaction was unlikely to generate fees to the banker from debt financing and criticizing the failure to disclose total amount of bankers’ fees, any contingencies to earning the fees, and total revenues, if any, recently received by the bankers from the buyout group).

5 See Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986).

6 Caremark Rx Inc. Shareholders Endorse $26 Billion Merger with Pharmacy CVS Corp., 10 Mergers & Acquisitions L. Rep. (BNA) No. 12 at 242 (Mar. 26, 2007).

7 In re Pure Res. S’holders Litig., 808 A.2d 421 (Del. Ch. 2002).

8 Press Release, Netsmart Technologies, Inc., Netsmart Shareholders Approve Merger (Apr. 5, 2007).



First CircuitIn re Organogenesis, CA No. 04-10027-JLT, 2007 WL 776425 (D. Mass. March 15, 2007)

The Federal District Court in Massachusetts recently held that plaintiffs firm Milberg Weiss, a powerhouse in shareholder litigation, could not act as lead counsel in a securities class action following the indictments of the firm and two of its partners. In light of the indictments, the court held that the lawyers did not satisfy the statutory requirements that lead counsel be “qualified, experienced, and able to vigorously conduct the proposed litigation.”

The case involved a putative class action alleging violations of the securities laws by certain officers and directors of medical products company Organogenesis, who allegedly made unduly optimistic statements about the company’s financial viability. Three days after plaintiffs moved to certify a class of shareholders, plaintiffs’ counsel Milberg Weiss and partner Steven Schulman were indicted on charges of paying improper kickbacks to lead plaintiffs in other cases. Defendants opposed class certification because, among other reasons, Milberg Weiss was allegedly inadequate Lead Counsel.

The court concluded that based on the pending criminal proceedings against Milberg Weiss and Schulman, the attorneys could not satisfy the requirement that they be “qualified, experienced, and able to vigorously conduct the proposed litigation.” According to the court, “Milberg Weiss has a respectable record and reputation for litigating securities class actions, the court cannot ignore the fact that by virtue of the indictment, Milberg Weiss is a different

firm than it once was.” The Court noted its concern over both the finding of probable cause inherent in the indictment, the firm’s delay in reporting the indictment to the Court, and what the Court considered the firm’s misleading notification to the Court. It also noted that the firm was likely to be distracted defending itself.

Third CircuitGalati v. Commerce Bancorp, Inc., No. 05-5157 2007 WL 934893 (3rd Cir. March 29, 2007)

In 2004, federal prosecutors indicted three officers of the Philadelphia subsidiary of Commerce Bancorp, alleging that they participated in a “pay to play” scheme with the Philadelphia Treasurer, Corey Kemp. The officers approved Kemp for personal loans, which he otherwise would not have been able to obtain, in exchange for Kemp steering municipal accounts to Commerce/Philadelphia. Commerce’s stock dropped 16 percent after the indictment, and investors filed several class action lawsuits against Commerce, three Commerce officers, and the three Commerce/Philadelphia officers. The defendants moved to dismiss, and the District Court granted the motion.

On appeal, the plaintiffs argued that the defendants violated Securities Exchange Act § 10(b) and Rule 10b-5 by failing to disclose the illegal acts by Commerce/Philadelphia officers. The Third Circuit disagreed, holding that while the information would have been material to investors, the defendants did not have a duty to disclose such information. The court reasoned that under Rule 10b-5, there is an affirmative duty to disclose only when insiders are trading, a statute requires

Circuit and State Round-Up05


disclosure, or correcting an inaccurate, incomplete or misleading prior disclosure. Since there was no insider trading or statute requiring disclosure, the court focused on whether there had been a misleading prior disclosure.

The plaintiffs pointed to several statements the bank made regarding deposit growth, and the strong performance of the bank’s public finance division, and argued that these statements were misleading because Commerce failed to disclose that some of that revenue was derived from illegal acts. The court disagreed, stating that accurate factual recitations of past earnings are not misleading and that all the other statements were non-actionable puffery. Because the plaintiffs failed to identify a single misleading statement made by the defendants, the Third Circuit affirmed the District Court’s dismissal of the complaint.

Fourth Circuit Teachers’ Retirement Sys. of Louisiana v. Hunter, 477 F.3d 162 (4th Cir. 2007)

The plaintiffs in Hunter alleged that Cree, Inc., a researcher and manufacturer of silicon carbide-based products, engaged in a series of fraudulent transactions that artificially inflated the price of Cree’s stock. The plaintiffs argued that all of these transactions violated § 10(b) and Rule 10b-5. The District Court disagreed and dismissed the complaint for failing to meet the heightened pleading standards of the PSLRA. The plaintiffs appealed to the Fourth Circuit.

The plaintiffs alleged that Cree engaged in several types of fraudulent and misleading transactions. First, the plaintiffs argued that Cree engaged in “channel-stuffing” by entering into a supply contract in which the other company purchased product in excess of its actual demand (thus inflating Cree’s

revenues). Second, the plaintiffs alleged that Cree engaged in a series of transactions with no economic substance by agreeing to (1) “sell” equipment with a side agreement to later repurchase it; (2) pay an inflated price for a company’s stock in exchange for payment for research and development services Cree never performed; and (3) pay an inflated purchase price for a company’s subsidiary with the understanding that the company would return the overpayment to Cree in a supply contract.

The court rejected these assertions, ruling that the plaintiffs had failed to plead sufficient facts to provide a basis for any of the allegations. The complaint mainly relied on the assertions of the CEO’s estranged brother, and the court ruled that the plaintiffs failed to state facts showing that he would have knowledge of the supposedly fraudulent transactions. The court also ruled that the plaintiffs failed to show that the transactions lacked economic substance, because the plaintiffs’ confidential sources were not specific enough and did not show that the witnesses would possess knowledge of the transactions in question. For example, one affidavit merely claimed that, “it was well-known within Cree that they had overpaid for a company with dim prospects.”

The court also found that the plaintiffs failed to allege any misleading statements or omissions, and that the plaintiffs failed to plead loss causation sufficiently. The court ruled that proving causation required more than a statement that, “plaintiffs purchased stock at an artificially inflated price.” Rather, the plaintiffs must plead causation with specificity so the court can evaluate whether the casual link exists. In this case, the plaintiffs failed to show loss causation because there was no evidence that the market reacted to the “true facts” about the transactions until the plaintiffs filed their lawsuit.



Fifth CircuitRegents of the University of California v. Credit Suisse First Boston, Inc., No. 06-20856, 2007 WL 816518 (5th Cir. 2007)

In this widely-publicized decision, the Fifth Circuit reversed the District Court’s class certification order and held that the defendant banks were not primarily liable under Rule 10b-5 for acts related to the Enron collapse.

The litigation arose out of a series of transactions the defendant banks engaged in with Enron. For example, the banks would agree to “buy” an Enron asset in exchange for a guarantee that if the bank could not find a bona fide purchaser in a certain period of time, Enron would repurchase the asset at a substantially inflated price. In the meantime, Enron would improperly book the revenue as a sale (which inflated revenues), rather than treating the transaction as a loan. Even though there was no allegation that the banks were fiduciaries of the plaintiffs, the District Court held that class certification was proper because a “deceptive act” includes participating in a “transaction whose principal purpose and effect is to create a false appearance of revenues.” Thus, the plaintiffs were entitled to rely on the class-wide presumption of reliance for omissions and fraud on the market.

On appeal, the Fifth Circuit rejected the District Court’s definition of “deceptive act.” First, the court held that the banks did not owe plaintiffs any duty to disclose the nature of the transactions, because the banks were not fiduciaries of the plaintiffs. Next, the court ruled that the District Court’s definition of “deceptive act” was inconsistent with the Supreme Court’s decision that Section 10 does not give rise to aiding and abetting liability. Instead, the court held that a “deceptive act” is defined as conduct

involving either a misstatement or a failure to disclose by one who has a duty to disclose. Because the banks did not have any duty to disclose, their actions could not qualify as deceptive acts. Rather, the banks’ acts merely aided and abetted Enron by making its misrepresentations more plausible. In addition, the banks did not act directly in the market for Enron securities, and so the banks clearly did not manipulate the market for Enron’s securities.

Thus, the court ruled that the District Court improperly certified the class. Because the banks did not engage in deceptive acts, and because they did not manipulate the market, there could not be a class-wide presumption of reliance, and without such a presumption class certification fails.

DelawareIn re Tyson Foods, Inc., No. Civ. A 1106-N.2007 WL 416132 (Del. Ch. Feb. 6, 2007)

In the Tyson case, the Delaware Court of Chancery defined the standards applicable to breach of duty cases arising from the “spring loading” of options, which refers to the granting of options to executives immediately before the company announces good news expected to raise the stock price. The Tyson complaint challenged the legality of $163 million in payments by Tyson Foods to members of the Don Tyson family and Tyson Foods’ board members.

In a case of options “spring loading,” the court held that “[f]irst, a plaintiff must allege that options were issued according to a shareholder approved employee compensation plan. Second, a plaintiff must allege that the directors that approved spring-loaded (or bullet-dodging) options (a) possessed material non-public information soon to be released that would impact


the company’s share price, and (b) issued those options with the intent to circumvent otherwise valid shareholder-approved restrictions upon the exercise price of the options.” Thus, the court seems to contemplate a showing of scienter that will be difficult for plaintiffs to demonstrate in the vast majority of cases.

Further, the court held that if spring-loading options did occur, it would violate the duty of loyalty, placing the conduct outside the protections of most director and officer insurance policies.

Ryan v. Gifford, No. CIV.A. 2213-N, 2007 WL 416162 (Del. Ch. Feb. 6, 2007)

The Delaware Court of Chancery recently issued its first decision associated with stock-options backdating. The Ryan case concerned millions of allegedly backdated stock options granted to John Gifford, Maxim’s founder, chairman of the board and CEO between 1998 and mid-2002. In early 2006, Merrill Lynch conducted an analysis of the timing of stock options granted between 1997 and 2002 by semiconductor and semiconductor equipment companies, including Maxim, which comprise the Philadelphia Semiconductor Index. Merrill Lynch found that the 20-day return on options granted to Maxim’s management averaged 14 percent over the five-year period between 1997 and 2002, which amounted to an annualized return of 243 percent – almost 10 times higher than the 29 percent annualized market returns in the same period. Based in part on this report, shareholder Robert McKinney filed a federal derivative action in the Northern District of California on May 22, 2006. Three weeks later, on June 2, 2006, a different plaintiff (Ryan) filed a shareholder derivative action in Delaware.

.The Court refused to stay the Delaware action in favor of the prior filed California suit because Delaware had not addressed “fundamental” issues such as “the propriety of this type of executive compensation, requisite disclosures that must accompany such compensation, and the legal implications of intentional non-compliance with shareholder-approved plans.” The Court’s opinion suggests, however, that once it has ruled on these “fundamental” issues, it would be far more likely to defer to a first-filed suit.

Further, the Court held that demand was excused. The Court noted that the fact that the option grants were “not at set or designated times, but by a sporadic method” that suggested the grants may have been manipulated. The Court went on to explain that “[b]ackdating options qualifies as one of those ‘rare cases [in which] a transaction may be so egregious on its face that board approval cannot meet the test of business judgment, and a substantial likelihood of director liability therefore exists.’” Moreover, the Court stated that a “director who approves the backdating of options faces at the very least a substantial likelihood of liability, if only because it is difficult to conceive of a context in which a director may simultaneously lie to his shareholders . . . and yet satisfy his duty of loyalty.”

Additionally, the Court classified stock options backdating as bad faith conduct. The Court explained it was “unable to fathom a situation where the deliberate violation of a shareholder approved stock option plan and false disclosures, obviously intended to mislead shareholders into thinking that the directors complied honestly with the shareholder-approved option plan, is anything but an act of bad faith.”


18 Securities Litigation and Professional Liability Practice, First Quarter 2007

Out In Front:

Sean Berkowitz (CH) and Richard Owens (NY) led a seminar series entitled “A Practical Guide to the Lessons Learned from Enron, WorldCom, Royal Ahold and Other Corporate Scandals.” These seminars drew upon their experience and expertise gained in prosecuting many high profile cases, such as Enron, Worldcom and ImClone Systems (the Martha Stewart case). The speakers gave first-hand insight into regulatory and criminal issues to be considered when doing business in the US, or involving US companies. The programs were held April 24th in Latham’s London office, April 25th in our Paris office and April 26 was at the Hotel MARITIM in Frankfurt.

Mark Finkelstein (OC) and Mike DeVries (OC) spoke at a seminar entitled “Electronic Discovery and Document Storage: Management and Litigation Issues” sponsored by Lorman Education Services. The seminar was designed to provide information on emerging trends in electronic media discovery practices. Topics included “Destruction of evidence and spoliation,” “Duties of in-house and outside counsel” and “Document retention and destruction guidelines,” among others. The event took place April 26th at the Residence Inn in Costa Mesa, CA.

John Huber (DC) was a panelist at the PLI program “Foreign Issuers & the US Securities Laws 2007: Strategies for the Changing Regulatory Environment,” which addresses how the SEC’s latest ruling on the deregistration of foreign issuers will affect your clients and your practice. Mr. Huber’s panel entitled “Risks and Benefits of a US Listing,” discussed offering reform and foreign issuers; deregistration by foreign issuers and transition to IFRS. The program took place May 2nd at the Practicing Law Institute in New York.

Mark Gerstein (CH), John Huber (DC) and Peter Kerman (SV) will be panel speakers at the 27th Annual Ray Garrett Jr. Corporate and Securities Law Institute, of which Latham is a sponsor. The Ray Garrett Institute is the premier conference of its kind and the only Midwest conference that provides cutting-edge presentations from both leading securities practitioners and senior officials from the Securities and Exchange Commission. The conference will be held May 3-4 at the Northwestern University School of Law in Chicago. For more information, please contact Joyce Simon (CH) at [email protected] or visit http://www.law.northwestern.edu/garrett/.

Latham will be presenting a multi-office General Counsel Forum on issues that are critical to every public company – when and how to provide earnings guidance. It will explore the legal framework as well as provide practical guidelines. This seminar will be interactive and should be of interest to directors, CEOs, CFOs, general counsel and investor relations personnel and will discuss: liability provisions, SEC safe harbors, duty to update, regulation FD, special considerations and helpful guidelines. The GC Forum will take place May 22nd, 23rd and 24th in our Chicago, Los Angeles, New York, Orange County, San Diego and Silicon Valley offices. For more information, please contact Nicole Williams (NY) at [email protected].

Laurie Smilan (VA) will be presenting at the PLI’s Audit Committee Workshop 2007: “What Audit Committee Members & Lawyers Who Advise Them Need to Know Now.” Ms. Smilan will be on the panel, “Audit Committee Member Liability.” The workshop will take place June 13th at the Practicing Law Institute in New York. For more information, please contact Andrea Rosson (DC) at [email protected] or visit www.pli.edu.

Recent and Upcoming Seminars and Speaking Engagements

05


Hanger Orthopedic GroupLatham secured dismissal with prejudice of a securities class action filed against Hanger Orthopedic Group, a leading provider of orthotic and prosthetic services and products, and its three top officers (the CEO, President and CFO). This action originally was brought in the Eastern District of New York but Latham succeeded in transfering the case to the District of Maryland. Plaintiffs filed their second amended complaint shortly after their transfer to Maryland. The Latham team briefed and argued a renewed motion to dismiss, drawing on several favorable in-circuit decisions obtained by Latham’s Northern Virginia securities litigators. The motion was granted, with prejudice, on three independently-sufficient grounds: failure to plead facts giving rise to a strong inference of scienter, failure to allege fraud with particularity and failure to establish loss causation. This represents another strong win by Latham securities litigators in the Fourth Circuit and produces case law precedent that will be helpful in future securities litigation matters. n

Deutsche Bank Securities Inc.Latham successfully represented Deutsche Bank Securities Inc. (DBSI), a subsidiary of Deutsche Bank AG, in connection with a securities action filed by Murray Capital Partners LLC (Murray Capital) against Exide Technologies Inc. (Exide) and certain of its employees, and DBSI. Murray Capital alleged that, in connection with a private placement offering of Exide’s securities, Defendants made material omissions and misrepresentations to induce it to purchase the securities, in violation of federal securities law and common law. n

In March 2005, Exide issued $350 million in notes, with DBSI serving as a lead underwriter. The offering memoranda included a statement expressing Exide’s expectation that it would be able to satisfy certain covenants of its senior credit facility, but, shortly after the offering, Exide announced that it would not be able to meet those covenants. In October 2005, Murray Capital filed a complaint in the United States District Court for the Southern District of New York, alleging that the offering memoranda were false or

misleading based on that failure to satisfy the debt covenants. It also alleged that a statement made by a DBSI analyst at a road show expressing a positive opinion of the investment opportunity was false or misleading. The complaint sought compensatory damages, rescission, reasonable costs and expenses, and punitive damages from all defendants. Both DBSI and Exide moved to dismiss the Complaint for failure to state a claim, and Judge Hellerstein granted those motions in a ruling from the bench after oral argument on August 21, 2006. n

In October 2006, Murray Capital filed an Amended Complaint containing more detailed allegations with respect to DBSI’s role in preparing the offering memoranda and alleging scienter based on DBSI’s relationship to Deutsche Bank AG (a lender under the senior credit facility). DBSI and Exide again filed motions to dismiss, and although the court allowed the case to proceed with respect to Exide and its employees, it dismissed DBSI, holding that the one statement made by the DBSI analyst was an inactionable statement of opinion and that the complaint did not properly attribute any other statements to DBSI. The court also noted that the complaint did not plead scienter with respect to DBSI. n

Bally Total Fitness Corp.Latham successfully represented Bally Total Fitness Corp. in the case of In re Bally Total Fitness Securities Litigation before the United States District Court for the Northern District of Illinois. The court dismissed the consolidated class action complaint without prejudice with leave to replead. Plaintiffs filed their amended complaint in August of 2006, giving rise to another round of motions to dismiss for failure to plead scienter. In February of 2007, Judge Grady issued a memorandum opinion and order granting all defendants’ motions to dismiss. This time, Judge Grady made dismissal with prejudice and entered final judgment in Bally’s favor. n

Recent Wins07


Chicago(�12) 87�-7700Sean BerkowitzJanet LinkBob Tarun

Frankfurt+�9 �9 �0�2-�000Bernd-Wilhelm Schmitz

London+�� 20 7710-1000John A. Hull

Los Angeles(21�) �85-12��Ethan BrownCharles CoxPeter DevereauxPamela PalmerRobert PerrinMarc RappelMiles RuthbergJamie Wine

New Jersey(97�) ��9.12��Larisa GjivojeAlan Kraus

New York(212) 90�-1200David BrodskyBlair ConnellyJoseph FrankJeff HammelChristopher HarrisRichard OwensAlexandra Shapiro

Northern Virginia(70�) �5�-1000Michele RoseLaurie SmilanJ. Christian Word

Paris+�� 1 �0�2-2000 Emmanuel DraiPatrick Dunaud

Orange County(71�) 5�0-12�5Jon AndersonPaul KonovalovMichele JohnsonPamela Palmer

San Diego(858) 52�-5�00Peter BenzianMichael Weaver

San Francisco(�15) �91-0�00Michele KyrouzJames LynchPeter Wald

Silicon Valley(�50) �28-��00Paul DawesPatrick GibbsJohn Tang

Washington, D.C.(202) ��7-2200William BakerDavid BeckerDouglas GreenburgEverett JohnsonKathryn RuemmlerDonald RemyEdward ShapiroLawrence West

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Securities Litigation and Professional Liability Practice Newsletter is published by Latham & Watkins LLP as a news reporting service to clients and other friends. The newsletter is edited by Mathias Fischer in Frankfurt, David Friedman in San Francisco and Kevin Metz in Washington, D.C. The information contained in this publication should not be construed as legal advice. Should further analysis or explanation of the subject matter be required, please contact the attorneys listed here or the attorney whom you normally consult. For more information, visit our Web site at www.lw.com.

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