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Improved corporate disclosures, increased personal accountability of officers, and an expanding role of audit committees and outside directors since the enactment of the Sarbanes-Oxley Act more than one year ago may deter fraud for companies, but time will tell whether the Act will, in fact, generate or prolong more litigation.
“There have been great changes in the way a company manages disclosures, enhancing and expediting the SEC 8-K filing, and expediting disclosures of discretionary insider sales,” Lisa Klein Wager, a partner with Morgan Lewis & Bockius, said. “Some of these reforms have already been effective, some are now mandating SEC rule-making,” said Wager, who moderated a panel at the 16th Annual International PLUS Conference.
Wager outlined for the PLUS attendees key provisions of the Sarbanes-Oxley Act and its implications for companies including class action litigation, more detailed management disclosure analysis, procedures and code of ethics disclosures. “There is greater responsibility by audit committees and a prohibition on personal loans to directors and officers,” she added.
Prior to enactment of Sarbanes-Oxley, it was projected that more cases would be filed because of whistle blowers, when, in fact, it has been just the opposite, Wager said. “Federal filings in 2003 thus far have been 252 compared with 503 in 2001.”
The likelihood of being sued has increased by 40 percent as a result of Sarbanes-Oxley, Wager added. “In 1995 they were 1.6 percent, today, they are 2.3 percent.”
Looking at the impact of the expanded statute of limitations on securities fraud, Robert Wallner, a partner with Milberg Weiss Bershad Hynes & Lerach LLP, said that traditionally in securities law, a plaintiff has to sue within one year after discovery of the fraud, but no more than three years after the fraudulent event. “The statute of limitations in section 804 of Sarbanes-Oxley has expanded the statute of limitations,” he said. “The plaintiff can now sue within two years after discovery of fraud, but no more than five years after the violation.
“One of the issues is the effective date of the statute,” Wallner added. “The Sarbanes-Oxley statute of limitations says that it will be effective for all cases commenced after the date of enactment of the statute, which is July 2002. Can the statute be used to initiate litigation where the claim was dead under the old statute of limitations? A number of Defense Investigative Service reports have held that Sarbanes-Oxley statute is retroactive.”
Wallner explained, “One of the purposes of Sarbanes-Oxley was to expand the statute of limitations in order to bring fraud cases that were not going to be prosecuted because of the statute of limitations. Let’s take the situation where a company waits four years to announce a restatement. That type of claim will likely be timely under the new statute. We are going to see prosecutions brought where they would have time-barred under the earlier statute.”
According to Wager, there is case law in other areas that if a statute intends to revive dead proceedings, the statute has to be explicit. “Sometimes the law offers a way of offering a simple answer and then you develop the right answer.”
In terms of the way companies conduct themselves as a result of Sarbanes-Oxley, Wager noted that it created a whole new regime of disclosure committees and people responsible for things they weren’t responsible for originally, including certification procedures. “There’s much more emphasis in the last year-and-a-half on how people create a record of what they’ve done to protect themselves. One of the concerns down the road is whether this going to generate more litigation or if it is going to make litigation more protractive when it begins.”
John McCarrick, partner, Duane Morris LLP, stated that Sarbanes-Oxley may make disclosure somewhat easier and at the same time more difficult. “This issue of due diligence is not unheard of,” he said. “We’ve always had, for example, in the 1933 Act under Sections 11 and 12 an affirmative defense that outside directors and other individuals could escape liability if they could prove by a preponderance of the evidence that they acted reasonably and in due care. How careful is a director going to be in saving documents and preparing memorandums? That has been an issue that has existed for years.”
Focusing on the cost of settlements since the Sarbanes-Oxley Act, Vinita Juneja, senior vice president, National Economic Research Associates, said that huge settlements—those over $100 million—are rare. “If we look at the distribution of settlements in first half of 2003, most were actually under $25 million,” she said. “There are only four settlements that are over $100 million.”
Settlements have been rising, according to Juneja. “The average settlement since Enron has been about $25 million and the trend is going up. However, if you look at a measure of exposure in these cases—investor losses—they have also been rising,” she said. “We measure investor losses as what the investors in each company have lost relative to what they would have made and lost had they invested in the S&P 500 instead. If we compare the average investor losses to the average settlements, we find that the investor losses have actually risen even more rapidly, so it doesn’t surprise us that settlement sizes have been rising rapidly.” There is good news for companies, Juneja said. “If we look, for example, at a company that had investor losses of $600 million and had certain characteristics, in 1998, we would have had a settlement of about $10 million. That same company with the same investor losses would now face expected settlement of slightly under $8 million.”
While investment losses are a major driver behind settlement values, there are a number of different factors to consider, according to Wager. “Types of plaintiffs should be considered. If in addition to common stock claims, you have debt holders, the settlement is more than 70 percent higher. If you have preferred share holders, on average, the settlement value adds about 60 percent. If you have option holders, you can add more than 30 percent to the settlement value.”
Wager said the types of allegations involved are also important. “If there is an allegation of accounting fraud, on its own it would add more than 10 percent. Admitting to accounting irregularities would add more than 20 percent. Alleged restatements or actual restatements would add almost 30 percent and accounting co-defendants would add more than 40 percent to the settlement value. When the case is settled also determines the settlement value.”
Issues from Sarbanes-Oxley will be with us over the next several years and there is still a lot to be resolved,” Wallner said. “The challenge for the insurance community, particularly the D&O community, is to get their arms around the issues,” he said. “Can insurers actually underwrite public companies, and if they can, what are the things they need to look at? Is it enough, for example, in underwriting due diligence, to meet with the CFO, to make sure the company is perfectly compliant? … Is that a deterrent to being sued? If not, is it a waste of time on the insurers’ part? That is something the insurance industry will have to struggle with.”