In April of 1998 Cendant disclosed a restatement of 1997 results, including a reduction in net income of $ 100 million due to various accounting irregularities. Then on July 14, 1998 Cendant announced a further restatement of financial results for 1995, 1996 and 1997, including all quarters due to recognition of fictitious revenues and cookie cutter reserve mismanagement. At the end of August Cendant filed an SEC report indicating a reduction in operating income of $ 500 million; a reduction in net income before taxes of $ 297 million and the effect on earnings per share. As a result, the market price of the stock decreased from a high of $35. in April to $11. per share in August. Normally a 10% drop in stock price following an adverse announcement is enough to trigger a class action suit within 72 hours. Here the drop was precipitous: 69%.
Fifty lawsuits were filed in the U.S. District Court which were consolidated by the judge with several institutional investors as the Lead Plaintiffs. Hundreds of thousands of documents were produced by Cendant, Ernst & Young and the various defendants. An investment banking firm and a forensic team were retained as expert witnesses. Cendant settled for $2.8 Billion. Ernst & Young settled for $ 335 Million. This settlement was followed by even larger valuations in the cases of WorldCom ($ 6.2 Billion) and Enron ($ 7.1 Billion, pending final court approvals).
Enron directors agreed to settle class action against them for $ 168 million as their proportionate share of the settlement. Insurance covered most of the cost, but left them with terms that required the directors to personally pay $ 13 Million. WorldCom directors had a General hashtag linkage to COVID-19 Pandemic settlement requiring them to pay their proportionate share, $ 54 Million, leaving them $ 18 million owed on a personal liability basis. The directors in the settlement admitted no wrongdoing.
Backdating Stock Options
The backdating scandal we are currently reading about in the Wall Street Journal may, according to academics, affect up to 3,000 publicly-held companies. Defense attorneys, plaintiff attorneys and expert witness are beginning to mobilize. This potentially massive arena of litigation and expert testimony has occurred because of the practice in the last ten years of publicly-held companies granting stock options to key executives which were in-the-money but not properly recorded as compensation expense, thus violating GAAP, and misstating tax liabilities as well over every quarter since the practice began. In other words, dates were assigned to the options using hindsight that were earlier dates than the actual grant date. The SEC has just begun an investigation into approximately eighty companies, and the list is expanding daily. The DOJ and U.S. Attorney offices are making logistic decisions as to how to allocate predicted case load. Several criminal charges have been filed. At a minimum, companies that are involved will face civil charges by the SEC, massive restatements and therefore the virtual guarantee of class action and derivative suits. The suits have as their basis that the companies in question and their top executives as well as boards of directors have engaged in breaches of fiduciary duty, gross mismanagement, unjust enrichment and violations of the SEC Act of 1934. Back-dated options have allowed the defendants to reap millions of dollars in unlawful windfall profits at the expense of the company. One law firm alone recently filed 34 derivative suits. It’s the largest area of civil litigation in history that is beginning to unfold before our very eyes.
Shareholder Derivative Suits
Shareholder derivative suits are increasingly filed in connection with class action suits. A primary concern is that directors and officers will find themselves without coverage for defense costs, awards for plaintiff’s attorneys fees and a monetary settlement. Director & Officer insurance policies sometimes exclude payments for non-civil litigation, as where certain types of fraud which involve scienter exist. Even if it does, usually the coverage does not begin until an indictment is brought. Another area that contains elements of peril is that often payments are made on a first-come, first-serve basis. In other words, in the order that claims are filed. This can often lead to a shortage in the case of a settlement.