SEC Enforcement: a Year in (P)Review by Elizabeth P

40737922 Securities LitigationREPORT in the Securities and Exchange Commission’s Division of Enforcement and as well as counselor to SEC Chairman ArthurLevitt.Contact:[email protected]@willkie.com. to counselor as well as and Enforcement of Division Commission’s Exchange and Securities the in Director Assistant as LLP.the Gallagher served & previously Farr of Gray Willkie Ms. of Department office D.C. Washington, Litigation the in associate an is Azam M. Joseph and partner a is P.Gray Elizabeth By ElizabethP. Gra A Year in(P)review SEC Enforcement: hs wrs ee o gend rm ac- from counts of the current meltdown in the gleaned mar not were words these however, enough, Oddly year. past the of crisis financial the of description apt more prevent areoccurrencegrows louder. to plan a and explanation an for demands of chorus the and continues crisis nancial fi- the from fallout the as authorities ment ofenforce- the priorities in heavily figure may that trends identify to attempts it so, may continue in the year-to-come. In doing tempts to forecast how these developments at - and year past the over enforcement ties securi- of area the in developments salient more the of some tracks article This end. history when the tumult finally comes to an of side right the on up end to rush a been has there authorities, enforcement to tives ticipatory sculpting of history. From execu- an- of sort similar a invited has crisis cial tion totheSouthPolein1912. his ill-fated attempt to lead the first expedi- famed British explorer Robert F. Scott after as a “Message to the Public” in the diary of kets. Rather, they were discovered scrawled n wud e adpesd o id a find to hard-pressed be would One In more ways than one, the recent finan- recent the one, than ways more In fore wehavenocauseforcomplaint. Werisks,took us, against them;out took come we have knew things we there and - y &JosephM.Azam - participants. The Commission’s attempt attempt Commission’s The participants. market high-level by transactions market illegal and trading insider on focused cases in were successes notable’s Commission’s the overall, cases enforcement of number substantial a and cases trading insider of Complete Table of Contents listed on page 2. page on listed Contents of Table Complete Shapiro, JeremyL.Goldstein&DavidE.Kahan. By MichaelJ.Segal,JeannemarieO’Brien,Adam Economic Environment Executive Compensation in a Challenging By William D.Johnston. Advancement Language Importance ofPaying Close Attention to Delaware CourtofChanceryDecisionsHighlight CONTINUED ONPAGE 4 FY 2008: Lasting Trends ments for the year.the for ments the Commission’s quantitative accomplish- of recital a include will 2008 FY in gram pro- enforcement Commission’s Exchange December/January 2009 Most any account of the Securities and and Securities the of account any Most Content

HIGHLIGHTS

1 ...... With a record number number record a With n Volume 6 ..... n 1 1 Issue1 4 0 Securities Litigation Report

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Editorial Board The Courts, Electronic Discovery, Joy A. Kruse Linda Mullenix & Plaintiffs’ Issues: Lieff Cabraser Heimann & Bernstein, LLP Professor of Law University of MANAGING EDITOR: Andrew B.Weissman San Francisco, CA Texas School of Law Austin, TX GREGG WIRTH Wilmer Cutler Pickering Hale & Dorr LLP Heather Fox Washington, DC SVP & Chief Underwriting Officer John F. Savarese CHAIRMAN: Alan Schulman AIG Executive Liability Wachtell, Lipton, Rosen & Katz Joseph M. McLaughlin New York, NY New York, NY Simpson Thacher & Bartlett LLP, University of San Diego New York, NY San Diego, CA Jonathan M. Hoff Sherrie R. Savett Lawrence Byrne Cadwalader, Wickersham & Taft LLP Berger & Montague , P.C. board OF EDITORS: White & Case LLP, New York, NY Philadelphia, PA Corporate Governance, Risk Management New York, NY Karin Kramer WARREN R. STERN & Professional Responsibility: James Benedict Howrey LLP, Wachtell, Lipton, Rosen & Katz Jonathan C. Dickey Milbank, Tweed, Hadley & McCloy San Francisco, CA New York, NY Gibson, Dunn & Crutcher LLP, New York, NY Robert A.Wallner Palo Alto, CA GRACE LAMONT Wayne M. Carlin PricewaterhouseCoopers Milberg LLP New York, NY Regulation, the SEC, and the Wachtell, Lipton, Rosen & Katz New York, NY New York, NY Department of Justice: Alfred J. Lechner, Jr. Michael R. Young Paul H. Dawes White & Case LLP Willkie Farr & Gallagher LLP Mark Radke New York, NY Dewey & LeBoeuf, LLP Latham & Watkins LLP, New York, NY Menlo Park, CA Washington, DC Paul Lomas Jordan Eth Freshfields Bruckhaus Deringer Morrison & Foerster LLP London San Francisco, CA

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Like many institutional investors, Colorado’s From the EDITORS PERA, which oversees about $41 billion in assets, has installed a new policy to help decide when the fund will pursue litigation. PERA’s policy sets a minimum loss threshold and urges litigation in To Sue or Not to Sue, Institutional cases where the outcome may have a deterrent Investors Ponder the Question effect on future behavior. “With policies such as these in place, we can really examine if bringing NEW YORK—One of the most important litigation is the best use of PERA’s resources,” questions plaintiffs’ counsel can ponder is wheth- Smith said. er or not to pursue litigation against a company “A fund’s investment is an asset like anything on behalf of shareholders. So important is this else,” Smith said. “And an asset has to be man- question that lawyers representing several large aged and cared for.” And sometimes that means institutional shareholders (who might have to ex- legal pursuit of those who may have damaged the amine this question dozens of times each month), asset. gathered together recently to discuss it. In this issue… The December/January issue of At panel entitled, “To Litigate or Not?”—part Securities Litigation Report—the combined last of a conference here on Global Shareholder Activ- issue of 2008 and the first of 2009—takes a long ism held Dec. 4-6 and sponsored by plaintiff law look at the past year in SEC enforcement. Author firm Grant & Eisenhofer—institutional investors’ Elizabeth P. Gray of Willkie Farr & Gallagher counsel chewed over the ins and outs of bringing LLP examines the Securities and Exchange Com- litigation. mission’s enforcement record looking back over David Muir, chief counsel of the Los Angeles the past year and looking ahead to the coming County Employees Retirement Association (LAC- year. With insider trading making a comeback in ERA) said pursuing litigation can be a “fiduciary 2008 as a source of SEC enforcement action, and obligation” in some cases. “It’s getting harder regulators looking at possible criminal causes of and harder to not get involved (in litigation),” the current market meltdown, the coming year is Muir told the group. “It’s very dangerous to just likely to bring more enforcement efforts. sit back and not do something, or not pay atten- Also in this issue, author William D. John- tion to cases.” LACERA oversees more than $40 ston, of Young Conaway Stargatt & Taylor, billion in pension and retirement funds of L.A. LLP, brings readers up to date on the issue of County. “advancement”—companies’ ability or obliga- Greg Smith, general counsel for the Public tion to advance defense costs to directors or of- Employees’ Retirement Association of Colorado ficers involved in litigation. Two recent cases, the (PERA), said in some cases it’s easy to know author argues, have emphasized the importance whether to litigate. “Insider trading cases, any of counsel paying close attention to this issue. case where someone took money from us and we Calling for stories… Securities Litigation Re- want to get it back, or any case where we might port always is looking for interesting story ideas have an issue that no one is addressing—those are concerning the ongoing markets crisis, new litiga- easy ones to decide,” Smith explained. Harder, tion trends, recent court decisions and the latest though are cases that may not be so clear cut. In developments. If you or someone at your firm has deciding to bring a case against Royal Ahold NV, an idea for an article—please contact our manag- Smith said PERA wanted to send a message to the ing editor, Gregg Wirth, at [email protected]. boards of foreign companies that fraudulent activity would not be tolerated wherever it occurs. —Joseph M. McLaughlin & Gregg Wirth

CONTINUED FROM PAGE 1 to reign in misconduct by hedge funds was also since 2005, Guttenberg signaled a focus on the a theme throughout the year, as was aggressive conduct of high-ranking market professionals that enforcement of the Foreign Corrupt Practices continued throughout this past year. Indeed, in Act. Throughout the year, the SEC’s continued its speaking about the Guttenberg case, Linda Chat- commitment to working in tandem with criminal man Thomsen, Director of the SEC’s Division authorities to prosecute securities fraud. of Enforcement, stated that it was “particularly pernicious when Wall Street insiders—who derive Insider Trading their already substantial livelihood from the capi- This past fiscal year saw an unprecedented num- tal markets and those markets’ investors—shame- ber of insider trading cases brought by the SEC, lessly compromise the markets’ integrity and in- with an increase of 25% from the previous year.2 vestors’ trust for a quick buck.”4 Perhaps more significantly, the SEC continued to Building on Guttenberg, the Commission con- pay increased attention to insider trading involv- tinued its focus on pursuing insider trading case ing hedge funds, a focus which may well have involving industry professionals as well as promi- peaked in March 2007 with the filing of SEC v. nent executives this year with a number of high Guttenberg et al.3 In Guttenberg¸ the SEC alleged profile filings. that 14 defendants, both individuals and hedge In January 2008, the Commission filed an insid- funds, were involved in insider trading schemes er trading complaint, SEC v. Raben et al., against for the better part of five years. These schemes two former employees of PriceWaterhouseCoo- consisted of hundreds of tips, over $15 million in pers LLP, alleging that the pair had used sensitive illegal trading profits, and the involvement of in- information that they had access to as a result of siders at UBS Securities LLC and Morgan Stanley their positions in the accounting firm to buy stock & Co., Inc. ahead of a series of corporate takeovers.5 Less In its complaint, the Commission alleged that than a month later, the Commission announced from 2001 through 2006, Mitchel S. Gutten- that it had settled a case involving a former Dow berg, an executive director in the equity research Jones & Co. board member and three other Hong department of UBS, tipped material, nonpublic Kong residents accused of illegal tipping and in- information concerning imminent upgrades and sider trading ahead of news of an unsolicited buy- downgrades to two Wall Street traders, Erik R. out offer from News Corp.6 As in the Guttenberg Franklin and David M. Tavdy, in exchange for case, the Commission in SEC v. Kan King Wong sharing in the profits from their trading on that et al. expressed its concerns about the fact that it information. In turn, Franklin and Tavdy tipped was a high-ranking member of the board directly their own downstream tippees who also traded on taking part in the misconduct.7 the information. The complaint alleged that from In May, the Commission continued its pursuit 2005 to 2006, an attorney in Morgan Stanley’s of industry professionals in SEC v. Gansman et global compliance department, together with her al., a case in which a former partner in Ernst & husband, also an attorney, tipped material, non- Young’s Transaction Advisory Services depart- public information concerning upcoming corpo- ment was charged with tipping a friend, a regis- rate acquisitions involving Morgan Stanley’s in- tered securities professional, about the identities vestment banking clients to a registered broker in of at least seven different acquisition targets of cli- Florida in exchange for sharing in his illicit trad- ents who sought valuation services from Ernst & ing profits. The broker himself had several down- Young.8 The tippee in this case used the nonpublic stream tippees who traded on the information. information to trade and passed it on downstream As the Guttenberg case drew to a close, it served to others who also traded on it. The Commission as a reminder of what likely informed the SEC’s noted that this case underscored the importance priorities with respect to insider trading over the of deal advisors and due diligence providers main- last year. In addition to the focus on hedge funds, taining confidentiality and the integrity of the which has been the subject of much discussion transactions which they help complete.

Finally, in what was one of the largest financial the funds’ growing troubles and allowing for an settlements with an individual for insider trading orderly wind-down of funds, the defendants in in the history of the SEC’s enforcement program, Cioffi allegedly made misrepresentations in hopes the Commission settled SEC v. Pai in July. The that the tides would shift and the funds would re- defendant in Pai settled charges by agreeing to a bound. five-year bar from serving as officer or director The ongoing interest of criminal authorities in of a public company and payment of $30 million SEC enforcement cases was demonstrated by the in disgorgement and prejudgment interest plus a parallel criminal proceedings brought by the U.S. $1.5 million penalty.9 In Pai, the SEC alleged that Attorney for the Eastern District of New York between May 18, 2001, and June 7, 2001, the against Cioffi and Tannin, charging the defendants defendant—former Enron executive Lou L. Pai— with one count of criminal conspiracy to commit sold 338,897 shares of Enron stock and exercised securities fraud and wire fraud, one count of in- stock options that resulted in the sale of 572,818 sider trading, two counts of securities fraud, and shares to the open market. According to the five counts of wire fraud.11 Of particular interest SEC’s complaint, Pai received material nonpublic were the government’s theories regarding the al- information from Enron Energy Services succes- leged criminal conspiracy and wire fraud, which sor management concerning certain financial and were based on language in three e-mails and state- operational problems and substantial contract- ments made in two phone conversations. While, related losses at the company. The complaint also according to the government, the purpose behind alleged that Pai avoided substantial losses from these statements was to entice investors to con- these sales when the price of Enron stock col- tinue to support the funds while the insiders were lapsed in 2001—Enron’s stock price averaged ap- selling, at least some of the language in question proximately $53.78 per share during the time of could in other contexts be categorized as aggres- Pai’s sales, but closed at 40-cents the day after the sive salesmanship. company filed for Chapter 11. In addition to actions taken in Cioffi, the SEC Hedge Funds continued to tread in relatively new territory created by the adoption of new rule 206(4)-812 The past year has seen a breadth of cases against which prohibits fraudulent and deceptive prac- hedge fund managers for violations running the tices by investment advisors to various types of gamut from fraud and misrepresentation to im- pooled investment vehicles. Adopted in response proper short sales and insider trading. to the D.C. Circuit Court’s decision in Goldstein Of the many cases brought by the SEC, one of v. SEC,13 the rule was used in several SEC enforce- the most significant of the year was SEC v. Cioffi ments actions this past year in situations involv- et al., one of the first enforcement actions stem- ing investment advisors who allegedly defrauded ming from the subprime mortgage crisis.10 In investors or prospective investors in hedge funds. Cioffi, the SEC charged two former Bear Stearns The rule, which is designed for broad applica- Asset Management portfolio managers—Ralph tion, does not require the fraud in question to be Cioffi and Matthew Tannin—for misleading in- in connection with the purchase or sale of a secu- vestors about the health of two of the firm’s larg- rity, nor does it have the scienter requirements of a est hedge funds and their exposure to mortgage- 10b-5 action. The SEC’s first case in this area came backed securities, while at the same time selling on November 26, 2007 in SEC v. Rabinovich & their personal positions in the funds. According Associates, LP, Alex Rabinovich et al.14 In Rabi- to the SEC’s complaint, the defendants in the case novich , the SEC alleged that the defendants, an were aware of the grave condition of the funds unregistered investment company and a broker but failed to disclose this information to investors dealer, sold limited partnership interests in an al- and institutional counterparties until the funds leged fund by cold-calling investors and severely collapsed in June 2007, leading to losses of ap- misrepresenting the performance of the fund as proximately $1.8 billion. Rather than disclosing well as the credibility of the investment company

itself. The Commission continued to use the new and Lehman Brothers.21 Using the broad author- rule 206(4)-8 throughout the past fiscal year in ity to investigate under Section 21(a) of the Se- similar contexts.15 curities Exchange Act, the Commission began an In addition to these cases, the Commission industry-wide investigation into short-selling and brought cases dealing with conflicts of interests rumor-mongering. In requesting e-mails, messag- and kickbacks,16 improper short sales,17 market es and phone transcripts, the SEC demonstrated a timing,18 and late trading,19 all of which will like- willingness to aggressively track down the sources ly continue to be areas of interest in the coming of potentially destabilizing false statements. The year. added focus on rumor-mongering may have been prompted by recent developments in case law on Short-selling & Rumor-Mongering short-selling requiring evidence of manipulative Short-selling became a major target if not regu- intent to violate the anti-fraud provisions. lators’ cause célèbre in FY 2008. The SEC and Courts had long agreed that even fairly aggres- other regulators seemed poised to intervene in sive short-selling could constitute a legitimate instances where short-selling schemes were being trading strategy and could in fact lead to pric- used as vehicles for market manipulation. ing efficiencies in the market.22 As recently as last During FY 2008, the Commission became in- year, the Second Circuit held that short-selling creasingly concerned that intentional spreading is not necessarily a problematic practice.23 In its of rumors in conjunction with aggressive short- decision in ATSI Communications v. The Shaar selling was contributing to the high levels of tur- Fund, Ltd., the court held that in order to reach bulence in the market. In SEC v. Berliner, the SEC levels constituting market manipulation, short- alleged that the defendant, a trader, intentionally selling “must be willfully combined with some- spread false rumors about Blackstone Group’s ac- thing more to create a false impression of how quisition of Alliance Data Systems and simultane- market participants value a security.”24 Essential- ously engaged in short-selling for a profit. ly, the Second Circuit’s holding in ATSI reinforced Several months after filing Berliner, on July 13, a notion adhered to in a number of other circuits the SEC announced that it was going to com- that the practice of short-selling is not inherently mence examinations aimed at the prevention of manipulative.25 the intentional spread of false information to ma- While ATSI itself was not ground-breaking, its nipulate securities prices. The examinations were progeny in the Second Circuit has raised eyebrows. to be conducted by the SEC’s Office of Compli- These cases have highlighted the tension that the ance Inspections and Examinations (OCIE), as recent market turmoil has created between legiti- well as the Financial Industry Regulatory Au- mate short-selling and short-selling designed to thority (FINRA) and New York Stock Exchange improperly manipulate the market. For example, (NYSE) Regulation.20 The announcement came at in In Re Amaranth Natural Gas Commodities a time when the SEC was already expressing con- Litigation, the court, effectively contradicting cern that compliance programs, while existent on previous decisions26 in the Southern District, held paper, were lacking adequate implementation and that the “something more” requirement in ATSI did not satisfy regulatory requirements. The ex- could be satisfied by the presence of an “improper aminations would be aimed at ensuring that the motive.”27 Indeed, the Second Circuit’s decision appropriate prophylactic measures were in place in ATSI may have cleared a path to the possibility to stave off rumor-mongering. of short-selling constituting actionable fraud even Almost immediately following its announce- in the absence of any other manipulative conduct ment, the SEC issued several dozen subpoenas to so long as there is an intent to manipulate securi- investment banks and hedge funds in an attempt ties prices.28 to track down the source of a number of rumors In the fall of 2008, the Commission attempted that allegedly contributed to, among other prob- to address the spike in abusive short-selling by lems in the market, the downfall of Bear Stearns adopting temporary and permanent rules regard-

ing abusive short-selling practices. The Commis- kickbacks totaling $280,000 to the Iraqi gov- sion’s use and interpretation of these new rules ernment. Akzo Nobel agreed to pay $3 million against the backdrop of ATSI and its progeny will in disgorgement, pre-judgment interest, and civil be of interest during the year ahead. penalties in connection with its settlement with the SEC.32 Enforcement & The Foreign Corrupt Two months later, Texas-based Flowserve Practices Act Corporation entered into a deferred prosecution As noted by the SEC itself, another significant agreement with the DOJ and settled books and re- growth area in FY 2008 was the Commission’s cords and internal controls charges with the SEC involvement in cases against public companies en- in connection with $600,000 in kickbacks made, gaged in the bribing of foreign officials, a violation and an additional $173,000 of kickbacks offered, of the Foreign Corrupt Practices Act (FCPA).29 to the Iraqi government by two of its subsidiaries. Since 2006, the Commission has brought 38 The company paid a $4 million criminal penalty FCPA enforcement actions, 15 of which came in and $6.55 million in civil penalties, disgorgement 33 FY 2008. This marks a continuing surge in activi- and interest. ty in this area as the actions brought from 2006 to In March 2008, AB Volvo settled charges two the present have outnumbered all those brought of its subsidiaries allegedly paid over $6 million in in previous years combined, dating back to the illicit kickbacks to the Iraqi government. As part passing of the FCPA in 1977. of its settlement with the SEC, Volvo agreed to The change in the SEC’s involvement in FCPA pay $12.6 million in civil penalties, disgorgement cases can be seen in kind as well as in number. and interest. This was in addition to the $7 mil- Traditionally, many of the cases brought by the lion criminal penalty it agreed to pay in relation SEC were initiated by the self-reporting of the to related to wire fraud and FCPA books and re- violators themselves. The trend that continued in cords charges.34 FY 2008, however, was that of cases generated The investigations into the Oil for Food pro- by leads that came from the SEC’s own investiga- gram-related misconduct came as a number of tions.30 Moreover, some of these investigations industry-wide investigations were also underway, have the potential for record-breaking penalties. including several involving oil & gas companies Perhaps the most prominent example of this is the and a number involving medial device compa- recently settled enforcement action against Ger- nies. man industrial goliath Siemens A.G. On Decem- The increase in the number and scope of FCPA ber 15, 2008, Siemens offered to pay a total of actions in the last several years has been attribut- $1.6 billion in disgorgement and fines, the largest ed to a number of factors, including in large part amount a company has ever paid to settle cor- to the growing cooperation between regulators in ruption-related charges. 31 The penalties will be the U.S. and their counterparts abroad. Perhaps paid to the SEC, the DOJ, and the Office of the equally significant, however, has been the increas- Prosecutor General in Munich, Germany. ing cooperation between the SEC and the DOJ While there were a number of notable FCPA in pursuing violations of the FCPA. In FY 2008, actions this year, some of the more prominent the DOJ took steps to address the demands of included actions stemming from the United Na- its involvement in FCPA cases by hiring several tions Oil for Food Program. These cases involved prosecutors dedicated exclusively to handle such books and records and wire fraud charges related cases. to kickbacks paid to the Iraqi government. Given the domestic and international coopera- In December 2007, Dutch pharmaceutical tion in enforcing the FCPA and the streamlining company Akzo Nobel N.V. entered into a non- and efficiency that has resulted, all indications prosecution agreement with the Department of are that enforcement actions dealing with inter- Justice and consented to an injunction with the national bribery will continue as an enforcement SEC related to allegations that subsidiaries made priority in FY 2009.

Other Areas to Watch work with these SEC on these cases. With the new compensation disclosure rules in place, the Com- The current fiscal year will likely see further in- mission will also consider whether compensation tensification of the government’s efforts to rein in disclosure by the issuers was adequate. or at least get a conceptual grasp on practices that could exacerbate the turmoil in the market. This A More Assertive OCIE regulatory vigor is in some respects similar to that SEC enforcement will also likely work more which followed the stock market crash of 1929 closely with OCIE on exam initiatives in the com- and led to the passage of the Securities Act of ing year. OCIE specifically stated what areas it 1934. Both then and now, regulators realized that certain practices and tactics were simply incom- sees as presenting the most significant risks in FY patible with a stable market and, in some cases, 2009. created risks of catastrophic failure. With a new These areas are to include: administration stepping in to oversee the financial • portfolio management; crisis, there may be dramatic changes in store for the SEC, including a restructuring or merger with • financial controls; other agencies. • valuation; Nevertheless, the SEC’s enforcement program is likely to have a number of focal points in FY • sales of structured products, particularly 2009. The areas already discussed will continue those marketed as being low risk; to be of high interest to the Commission. There are, however, a few other key areas to watch in • controls and processes at recently merged or the coming year. acquired firms; Misrepresentation of Risk and • money market funds, especially with regard Accounting Failures to exposure to undisclosed risks; Almost certainly, there will be a renewed inter- • short-selling; est in issuer misrepresentations and accounting • and the manipulation of securities prices failures, particularly regarding the risks taken in through rumors and false statements.35 the credit markets and mortgaged-backed securities. OCIE has also signaled that its future examina- In the wake of the credit crisis and mortgage tions are likely to be more regimented and more meltdown, SEC enforcement is likely to refocus demanding. For example, in November, OCIE its efforts on the investigation of issuers and their published a detailed description of the informa- officers and directors to determine whether they tion its examiners will request in advance of on- properly disclosed the risk they assumed on their site investigations of investment advisers.36 In balance sheets, in their investment portfolios and publishing its “core initial request,” OCIE out- in their business models. The SEC may focus on lined five categories of information that targets of failed institutions such as Lehman Brothers and an examination should be prepared to present to their leaders to determine whether public state- examiners: ments accurately reflected risks, as well as on 1. general information about business and in- whether leaders of these institutions were improperly compensated. Having successfully charged vestment activities; the managers of failed hedge funds in Cioffi, the 2. information about any compliance programs, SEC is likely to pursue these cases aggressively. internal controls, and risk management; The involvement of the U.S. Attorney’s Office for the Eastern District of New York in Cioffi sug- 3. documents relating to any transactional and gests that the Justice Department will continue to periodic testing;

4. any actions taken to respond to violations of Notes a compliance program; and 1. seC Press Release, “SEC Announces Fiscal 2008 5. information about compliance in other ar- Enforcement Results-Agency Brings Second- Highest Number of Actions Ever; Significant eas, including but not limited to financial re- Increase in Insider Trading and Market cords. Manipulation Cases” (Oct. 22, 2008) available at The import of the “core initial request,” how- http://www.sec.gov/news/press/2008/2008-254. ever, was not necessarily in its details but rather htm. 2. See SEC Press Release, supra, note 1. in the fact that it offered a standardized baseline 3. Civil Action No. 07 CV 1774 (S.D.N.Y.) (PKC). that targets of examinations would now have to 4. statement Concerning SEC v. Guttenberg by be aware of and account for in their responses Linda Chatman Thomsen, Director, Division to the OCIE. Insofar as the OCIE considers such of Enforcement, U.S. Securities and Exchange publications as fair warning of its expectations of Commission (March 1, 2007) available at http:// its targets, there will likely be swift action by the www.sec.gov/news/speech/2007spch 030107lct. enforcement authorities when the work of the ex- htm. aminers is obstructed by failure to comply with 5. seC Press Release, “SEC Charges Two Former the requirements set forth in examination guide- Accounting Firm Employees with Insider Trading” (Jan. 15, 2008) available at http://www.sec.gov/ lines. This has already been demonstrated in the news/press/2008/2008-6.htm. early months of the new fiscal year. 6. seC Press Release, “SEC Charges Former Dow In November, the Commission won a decision Jones Board Member, Three Other Hong in a case where a broker-dealer was held respon- Kong Residents in $24 Million Insider Trading sible, under a theory of respondeat superior, for Settlement” (Feb. 5, 2008) available at http:// failing to retain and produce relevant e-mails in www.sec.gov/news/press/2008/2008-11.htm. response to an SEC investigation.37 The informa- 7. See SEC Press Release, supra. note 6. tion in question was maintained and destroyed by 8. seC Press Release, “SEC Charges Former Ernst & a registered representative and branch manager Young Partner and Friend With Insider Trading” (May 29, 2008) available at http://www.sec.gov/ of the broker-dealer. However, the Commission news/press/2008/2008-101.htm. sought to impose liability on the broker-dealer, 9. seC Press Release, “SEC Announces Insider Trading perhaps in an effort to drive home the fact that Charges Against Former Chairman and CEO of there is no shirking of the responsibility for main- Enron Energy Services” (July 29, 2008) available taining proper records and, perhaps more impor- at http://www.sec.gov/news/press/2008/2008-151. tantly, producing them to regulators in the course htm. of investigations and examinations. 10. Civil Action No. 08-2457 (FB) (E.D.N.Y.). 11. See Indictment of Ralph Cioffi and Matthew Parting Thoughts Tannin (E.D.N.Y. June 19, 2008). 12. SEC Press Release 2007-133 (July 11, 2007). While many of those involved in the financial 13. Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006). crisis remain in the latter stages of hand-wringing, 14. SEC v. Rabinovich & Associates, LP, Alex Rabinovich enforcement authorities have become increasingly et al., 07 Civ. 10547 (GEL) (S.D.N.Y.). forceful in their reactions over the last fiscal year. 15. See, e.g., SEC v. Jason R. Hyatt and Jay Johnson et For targets of these investigations and enforce- al.¸ Civil Action No. 1:08-CV-2224 (N.D. Ill. Apr. 18, ment actions this means new thresholds to meet, 2008) (Lindberg, J.); SEC v. Plus Money, Inc. and Matthew La Madridd, et al., Case No. 3:08-CV- more demanding timelines, and smaller margins 00764-BEN-NLS (S.D. Cal. May 5, 2008). for error. For those advising them, it means re- 16. See, e.g., In Matter of Michael R. Donnell, Admin. assessing the dominant thinking that has sufficed Proc. File No. 3-12986 (Mar. 11, 2008). for decades and, perhaps, following the lead of 17. See, e.g., In Matter of DKR Oasis Management the regulators in moving from a reactive to a pro- Company, L.P., Admin Proc. File No. 3-13067 (June active approach. 12, 2008).

18. See, e.g., In Matter of Chronos Asset Management 35. See Speech by SEC Staff: Compliance Through and Mitchell L. Dong, SEC Admin. Proc. File No. Crisis: Focus Areas for SEC Examiners and 3-12934 (Jan 25, 2008). Compliance Professionals (Oct. 21, 2008) available 19. See, e.g., In Matter of Pritchard Capital Partners at http://www.sec.gov/news/speech/2008/ LLC, et al., SEC Admin. Proc. File No. 3-12753 (July spch102108lar.htm. 10, 2008). 36. See Office of Compliance Inspections and 20. SEC Press Release, “Securities Regulators to Examinations Investment Adviser Examinations: Examine Industry Controls Against Regulation Core Initial Request for Information (November Manipulation of Securities Prices Through 2008) available at http://www.sec.gov/info/cco/ Intentionally Spreading False Information” (July requestlistcore1108.htm#P4_49. 13, 2008) available at http://www.sec.gov/news/ 37. In the Matter of vFinance Investments, Inc., press/2008/2008-140.htm. Nicholas Thompson and Richard Campanella, 21. “Agency Subpoenas Focus on 4 Rumors Initial Decision No. 360; File No. 3-12918 (Nov. 7, That Hit Lehman,” Wall Street Journal 2008) available at http://www.sec.gov/litigation/ (July 28, 2008) available at http://online. aljdec/2008/id360rgm.pdf. wsj.com/article/SB121720520948988699. html?mod=googlenews_wsj. 22. See Brian A. Ochs, “When Does Short-Selling Become Manipulation?,” BNA’s Securities Regulation and Law Report, Vol. 40, No. 46 (Nov. Delaware Court 24, 2008). 23. See ATSI Communications, Inc. v. Shaar Fund, Ltd., 493 F.3d 87, Fed. Sec. L. Rep. (CCH) P 94363 of Chancery (2d Cir. 2007). 24. ATSI, 493 F. 3d at 101. Decisions Highlight 25. See Sullivan & Long, Inc. v. Scattered Corp., 47 F.3d 857, Fed. Sec. L. Rep. (CCH) P 98617 (7th Cir. Importance of Paying 1995); GFL Advantage Fund, Ltd. v. Colkitt, 272 F.3d 189, Fed. Sec. L. Rep. (CCH) P 91634 (3d Cir. 2001). Close Attention 26. See, e.g., Nanopierce Technologies, Inc. v. Southridge Capital Management, Slip Copy, 2008 to Advancement WL 1882702 (S.D.N.Y. 2008). 27. In re Amaranth Natural Gas Commodities Language Litigation, 2008 WL 4501247 (S.D. N.Y. 2008). 28. See Ochs, supra. note 21. By William D. Johnston 29. See SEC Press Release, supra. note 1. 30. See “Larger Foreign Corrupt Practices Act William D. Johnston is a partner in the Wilmington, Dela- Fines Ahead,” The National Law Journal ware-based law firm of Young Conaway Stargatt & Taylor, (Nov. 25, 2008) available at http://www.law. LLP. He is the immediate past chair of the firm’s Corpo- com/jsp/law/international/LawArticleIntl. rate Counseling and Litigation practice group. Contact: jsp?id=1202426258993. [email protected]. 31. SEC Press Release, Litigation Release No. 20829 (Dec. 15, 2008) available at http://www.sec.gov/ Two recent decisions from the Delaware Court litigation/litreleases/2008/lr20829.htm. of Chancery have emphasized the importance of 32. SEC Press Release, Litigation Release No. 20410 practitioners paying close attention to the lan- (Dec. 20, 2007) available at http://www.sec.gov/ guage of “advancement” provisions in the gov- litigation/litreleases/2007/lr20410.htm. erning documents of Delaware corporations and 33. SEC Press Release, Litigation Release No. 20461 other business organizations. The cases are Schoon (Feb. 21, 2008) available at http://www.sec.gov/ 1 litigation/litreleases/2008/lr20461.htm. v. Troy Corp. and Sun-Times Media Group, Inc. 2 34. SEC Press Release, Litigation Release No. 20504 v. Black. The Schoon decision was appealed, but (March 20, 2008) available at http://www.sec.gov/ the matter was settled prior to being heard by the litigation/litreleases/2008/lr20504.htm. Delaware Supreme Court. The Sun-Times Media

Group decision was not appealed. Accordingly, contrast, the Court found, Bohnen’s rights under each decision currently constitutes persuasive—if the pre-amendment bylaws had not been triggered not controlling—precedent under Delaware law. prior to the amendments because he had not been named in certain affirmative defenses and was not Schoon & Advancement to a Former a party to the lawsuit at issue. Director The Court of Chancery likewise rejected Boh- nen’s argument that, even if the amendments to In Schoon, plaintiffs included Richard W. the bylaws were effective, they failed to terminate Schoon, a current director of Troy Corp., a Dela- his right to advancement because of other lan- ware corporation, and Linda J. Bohnen, executrix guage in the bylaws. In particular, Bohnen relied of the estate of former Troy director William J. on language that read, “The rights conferred by Bohnen. They sued Troy for advancement of de- this Article shall continue as to a person who has fense expenses in connection with fiduciary duty ceased to be a director or officer and shall inure to claims first threatened and then filed by the com- the benefit of such person and the heirs, executors, pany. On cross-motions for summary judgment, administrators and other comparable legal repre- Vice Chancellor Stephen P. Lamb concluded that, sentatives of such person.” The Court found that under the governing bylaws, William Bohnen was the quoted language did not aid Bohnen’s cause not entitled to advancement but Schoon was. because he had resigned before Troy initiated its The Court recounted that Troy had adopted fiduciary duty claims against him: “Rather, it is several amendments to its bylaws and that those better understood as providing that a director, amendments “establish different advancement whose right to advancement is triggered while in rights for Bohnen, as a former director, and office, does not lose that right by ceasing to serve Schoon as a current director.” Quoting from the as a director.” In addition, the Court found that plaintiffs’ brief, the Court observed, for purposes the bylaws as amended would still provide for of the cross-motions, that the plaintiffs assumed indemnification of former directors. The Court “that the amendments were validly adopted.” concluded, “In short, the language of the bylaws Troy’s pre-amendment bylaws had provided deliberately and unambiguously provides for un- that “the Corporation shall pay the expenses in- equal treatment of current and former directors in curred by any present or former director….” The receiving advancement.” amended provision read, “[l]osses reasonably in- The Schoon decision has been criticized by curred by a director or officer in defending any some commentators as sanctioning a corpora- threatened or pending Proceeding … shall be paid tion’s unilateral and retroactive extinguishment by the Corporation in advance of the final dispo- of advancement and indemnification rights.4 But sition….” Troy told the Court that the purpose of it would seem that that conclusion is overbroad. the amendment was to “delete former directors Undeniably, the Schoon court, on the facts pre- from entitlement to advancement.” sented, did find that the claimant former director Bohnen contended that his advancement rights was not entitled to further advancement.5 But, in the pre-amendment bylaws vested before the doctrinally, what the Court concluded was that adoption of the amendments—at the time he took the right to advancement never “vested” in the office as a director. In support of his argument, he first place because it had not been triggered dur- relied upon the decision of the Delaware Supe- ing the time Bohnen was in office as a director. In rior Court in Salaman v. National Media Corp.3 addition, the distinction that the Court endorsed The Salaman court had stated that “the right between former and current officers or directors to advancement and indemnification is a vested is supported by the language of Section 145(e) of contract right which cannot be unilaterally termi- the Delaware General Corporation Law (DGCL): nated.” But Vice Chancellor Lamb noted that the “Such expenses (including attorneys’ fees) in- plaintiff in Salaman had been named as a defen- curred by former directors and officers or other dant before the bylaw at issue was amended. In employees and agents may be so paid upon such

terms and conditions, if any, as the corporation Court, looking to the language of Section 145(e) deems appropriate.” The Schoon court accord- and the company’s bylaws, to what it viewed as ingly referred to “the flexibility inherent in sec- the parties’ course of performance under the by- tion 145.” laws, and to practical and policy considerations, What, then, is the practical takeaway from concluded that “a final disposition is not reached the Schoon decision? It would seem that, if the until there is a final, non-appealable conclusion intention of the a corporation and an incoming to a proceeding.” The Court continued: “To find director or officer is to have advancement and otherwise would be to interpret § 145(e) as creat- indemnification rights vest at the time of taking ing a patchwork system of advancement that fails office, rather than at some later time, that can to provide advancement to officials for the appeal and should be explicitly stated in the governing of an adverse trial court judgment. Moreover, do- documents—whether bylaw provisions, charter ing so would contradict Delaware’s policy of en- provisions, or a separate agreement. In addition, couraging officials to resist unjustified lawsuits by the governing document(s) can and should make discouraging them from appealing adverse trial clear that any indemnification or advancement court judgments. In turn, that might discourage protection may be increased, but not diminished qualified individuals from serving at Delaware (much less wholly abrogated), by amendments to corporations.” bylaw or charter provisions or, for that matter, by The Sun-Times had argued, in essence, that in a change in the law.6 order for there to be advancement entitlement in Sun-Times & Appeal Advancement connection with an appeal, the corporation would have to have opted-in for such protection, explic- Similarly emphasizing the critical importance of itly referring to rights on appeal (as can and does the language of advancement provisions in gov- occur in practice). The Court disagreed, effective- erning organizational documents is the Court of ly imposing a duty to opt out of such protection if Chancery’s decision in Sun-Times Media Group, that is the corporation’s intention. Otherwise, in Inc. v. Black, et al. There, plaintiff Sun-Times the absence of such an opt-out, “final disposition” Media Group, Inc., formerly known as Hollinger will be understood to include the conclusion of International Inc., sought a declaration that it had all direct appeals in criminal proceedings (not ap- no obligation to continue to advance to defen- plications for post-conviction relief). Presumably, dants Conrad M. Black, John A. Boultbee, Peter the Court of Chancery would conclude likewise Y. Atkinson and Mark S. Kipnis after those indi- in connection with entitlement to advancement in viduals had been sentenced in a criminal proceed- defending an appeal in a civil proceeding, but that ing.7 At issue was the meaning of the words “the decision awaits another day. disposition of such action, suit or proceeding” So, what is the practical upshot of the Sun- as used in the Sun-Times’ bylaws and in Section 145(e) of the DGCL. The defendants contended Times Media Group decision, since the decision that the final disposition of a proceeding does not was not appealed? Until the issue is presented to occur until the final, non-appealable conclusion the Delaware Supreme Court in another matter, to that proceeding and that, as a result, the com- practitioners would be well to heed the guidance pany should be obligated to continue to advance of the Court of Chancery: “A corporation could defense expenses through the appeals of their grant mandatory advancement but circumscribe criminal convictions and sentences. that obligation so that it explicitly excludes ad- Vice Chancellor Leo E. Strine, Jr. denied the vancement for costs incurred in connection with Sun-Times’ motion for partial summary judg- any appellate stages of a proceeding.”9 Failure to ment and sua sponte granted summary judgment heed that guidance presumably may result in a to the defendants, concluding that the company corporation learning, to its surprise, that it will was required to continue to advance expenses have been deemed to have exercised discretion to until the conclusion of all direct appeals.8 The agree to advance appellate fees and expenses to

current or former corporate officials no matter Notes the outcome at trial. 1. Schoon v. Troy Corp., 948 A.2d 1157 (Del. Ch. Even if advancement is not available to a for- 2008). mer director or officer because that protection has 2. Sun-Times Media Group, Inc. v. Black, 954 A.2d been stripped away as in Schoon, the former di- 380 (Del. Ch. 2008). rector presumably cannot be deprived of the ben- 3. Salaman v. National Media Corp., 1992 WL efit of mandatory indemnification, pursuant to 808095 (Del. Super. Ct. 1992). Prior to the Section 145(c) of the DGCL, if he or she has been adoption of Section 145(k) of the Delaware “successful on the merits or otherwise” at the end General Corporation Law (8 Del. C. § 145(k)) in of the matter. And, depending upon the language 1994, both the Delaware Superior Court and the Delaware Court of Chancery could exercise of the governing documents, the former director subject matter jurisdiction over indemnification may be entitled to permissive indemnification pur- and advancement disputes. Section 145(k) suant to Section 145(a) or Section 145(b) of the vests the Court of Chancery “with exclusive DGCL even if he or she cannot meet the standard jurisdiction to hear and determine all actions for mandatory indemnification. Likewise, even if for advancement of expenses or indemnification a corporation does choose to opt out of providing brought under this section or under any bylaw, advancement in connection with appellate pro- agreement, vote of stockholders or disinterested ceedings (or any other proceedings), the director directors, or otherwise.” or officer claimant still may seek indemnification 4. The National Association of Corporate Directors (NACD), which had served as amicus curiae of fees and expenses at the end of the matter. in Schoon while the advancement decision Finally, for the corporation or other business was on appeal before the Delaware Supreme organization that finds itself with governing doc- Court, filed a motion to vacate the Court of uments that (under the Sun-Times Media Group Chancery’s holding in the case after Bohnen holding) mandate advancement of fees and ex- and Troy filed a stipulation of dismissal in the penses in connection with an appeal, there may appeal and the Supreme Court approved the be some comfort in knowing that Delaware law dismissal. The NACD’s motion requested that requires repayment of amounts advanced if it ulti- “the trial court’s decision be vacated in order to mately is determined that the advancement recipi- eliminate its precedential effect” and suggested in the alternative that the Supreme Court “act ent is not entitled to indemnification. Of course, sua sponte to order the opinion of the Court the criminally convicted former corporate official below vacated.” The Supreme Court, by Order may be judgment-proof by that time. Corpora- dated November 13, 2008, refused the motion to tions wanting to guard against such a risk may vacate, finding that it no longer had jurisdiction seek to impose conditions on advancement such over the appeal. Bohnen v. Troy Corp., 2008 Del. as requiring security. Whether a top-quality direc- LEXIS 514 (Del. Nov. 13, 2008). tor or officer candidate will agree to such condi- 5. Bohnen had received from Troy advancement tions may be another matter. of certain attorneys’ fees and other expenses in connection with opposing Troy’s motion to Conclusion amend its answer in a books and records action to assert counterclaims against Schoon, Bohnen, In sum, Delaware law provides substantial and others. Schoon, 948 A.2d at 1162-63. The flexibility in determining whether advancement Court concluded that, to the extent Bohnen had of defense expenses will be provided and, if so, not received all of these fees and expenses, he under what circumstances. Real-life negotiation was entitled to such. Schoon, 948 A.2d at 1168 of advancement provisions may result in certain n.49. 6. See 8 Del. C. § 145(f) (“The indemnification and language being left “on the cutting room floor.” advancement of expenses provided by, or granted But, as the Schoon and Sun-Times Media Group pursuant to, the other subsections of this section decisions demonstrate, careful consideration of shall not be deemed exclusive of any other the consequences of using—or not using—that rights to which those seeking indemnification or language is imperative. advancement of expenses may be entitled under

any bylaw, agreement, vote of stockholders or disinterested directors or otherwise, both as to action such person’s official capacity and as to Executive action in another capacity while holding such office.”). 7. The author and his law firm served as Delaware Compensation counsel to Sun-Times Media Group, Inc. in the case. in a Challenging 8. The Final Judgment and Order entered by the Court on September 29, 2008 stated in part, Economic “The Sun-Times shall continue to advance reasonable attorneys’ fees and other expenses Environment to the defendants until the final disposition of By Michael J. Segal, Jeannemarie United States v. Black, et al., 05 CR 727 (N.D. Ill.), O’Brien, Adam J. Shapiro, Jeremy that is, until all direct appeals in that proceeding L. Goldstein & David E. Kahan and any remands therefrom, together with any Michael J. Segal, Jeannemarie O’Brien, Adam J. Shapiro, additional direct appeals are resolved or the time Jeremy L. Goldstein and David E. Kahan are attorneys for filing any direct appeals shall have expired.” in the Executive Compensation and Benefits practice at 9. The Court stated, “Section 145(e) serves only to Wachtell, Lipton, Rosen & Katz LLP. Contact: jlgoldstein@ wlrk.com. authorize corporations to provide advancement to their officials and allows corporations to contractually limit that right.” In a footnote As 2008 draws to a close and companies con- appended to that sentence, the Court quoted tinue to weather the worst economic climate in a from other Delaware case law to the effect that generation, compensation committees and senior Section 145(e) is “permissive, not mandatory,” management will confront unprecedented chal- and that “a corporation is free to limit the terms lenges in 2009. This article describes key compen- of advancement and even preclude advancement sation issues that have emerged as a result of the entirely.” Sun-Times Media Group, Inc., 954 A.2d financial downturn. at 406 n.104. Stock Options Deeply Underwater The stock market swoon has resulted in employees of many companies holding a significant number of deeply underwater stock options. Compensation committees may determine that those options have lost meaningful incentive and retentive value. Under these circumstances, a compensation committee may wish to consider making a one-time special option grant, or accel- erating the 2009 option grant, in order to take advantage of depressed share prices and restore the incentive and retentive impact of company options. Similarly, tandem or independent grants of restricted stock or restricted stock units may promote retention and ensure that equity awards have some value regardless of stock price performance. Of course, any special equity grants will deplete available shares under equity plans and increase share overhang and may generate unfair

criticism that employees have effectively “doubled If a company does not have adequate shares up” on their equity compensation opportunity. available under its plans to make new equity As discussed below, an option exchange program grants, it may make grants subject to sharehold- may mitigate some of these concerns. er approval; however, a contingent award may A company may conduct an exchange offer in have a decreased incentive and retentive impact. order to replace deeply underwater options with A company may also grant awards outside of its fewer, newly granted at-the-money options, or existing plans in the form of cash-settled phan- other equity-based awards such as restricted stock tom equity or stock appreciation rights, although units. Option exchange programs typically raise cash-settled awards will result in “mark-to-mar- considerations under securities laws (a company ket” accounting, and awards granted outside of must file a Schedule TO, leave an offer open for a shareholder approved plan will not satisfy the at least 20 days and describe the exchange pro- performance-based exception of Section 162(m) gram in the next filed annual proxy statement), of the Internal Revenue Code. accounting rules (an exchange may result in additional compensation expense) and stock exchange Annual Bonus Goals Not Attained requirements (other than in the case of the rare Many companies will find that 2008 - per equity plan which specifically permits repricing, formance will result in bonus goals not being a company must obtain shareholder approval). achieved. In that case, a compensation committee In general, RiskMetrics will recommend share- must decide whether to use its business judgment holder approval of an option exchange program to override the applicable performance goal and only if (i) there is a compelling rationale for the make discretionary bonus payments in order to program, (ii) the exercise price of the surrendered promote retention or to reward outstanding in- options exceeds the 52-week high trading price of dividual performance. With respect to named ex- the stock, and (iii) executive officers and directors ecutive officers, a compensation committee must are excluded from the program. While a program disclose the rationale for overriding an objective which offers to exchange options for cash does bonus formula in the Compensation Discussion not require shareholder approval under stock and Analysis of the 2009 proxy statement, and exchange rules, RiskMetrics typically will recom- may need to report on a Form 8-K bonus pay- mend that shareholders withhold votes against ments made despite non-satisfaction of perfor- the compensation committee members of a com- mance goals. Any such discretionary bonuses pany that engages in a cash-for-options exchange will not qualify as “performance-based compen- program without shareholder approval. sation” for purposes of Section 162(m), and the compensation committee should carefully docu- Unexpectedly Large Equity Award ment the rationale for such payments in order to Grants preserve the performance-based compensation exemption under Section 162(m) for future bo- Many companies determine the number of eq- nuses. uity awards granted to employees by reference to Given the possibility of significant economic a specified dollar value. If a company’s stock price volatility in 2009 and the generally uncertain has declined precipitously, strict application of a business climate, compensation committees may formulaic award level can result in equity grants wish to consider “smoothing” the bonus formula with respect to an unexpectedly large number of by adopting quarterly or semi-annual goals and/ shares and can accelerate depletion of a plan’s or increasing reliance upon subjective measures share reserve. Under these circumstances, the rather than strict, pre-established performance grant of “full value awards” (such as restricted goals. It is possible to structure a bonus program stock or restricted stock units), rather than stock to both preserve Section 162(m) deductibility options, may make sense in order to maximize and maintain flexible objectives by adopting an plan share usage. “umbrella” performance goal for the entire year

that establishes a maximum award that may be reduced due to the compensation committee’s exercise of “negative discretion” based on applica- RiskMetrics tion of subjective and/or short terms goals. Problems Retaining Employees 2009 Corporate While job opportunities may be limited in the Governance Policy current environment, the most critical employees are often the most likely to have alternatives. If a Updates and Process company determines that employees are at risk of leaving, it may be wise to develop a special reten- RiskMetrics Group is a global financial risk man- tion program of cash or full-value equity awards agement firm that provides risk management, that vest over time. Such a program will provide corporate governance and financial research and tangible incentives for employees to remain com- analysis for financial institutions and corpora- mitted even if the company’s stock price declines tions worldwide. The following article is pub- after grant. Companies should specify whether to lished with permission from the Executive Sum- include any such retention awards in the formula mary of the firm’s annual Corporate Governance to determine severance and retirement benefits, Policy Updates and Process, which describes the and how such awards may affect regularly sched- firm’s core policies for the 2009 proxy season, uled annual equity grants. which will be in effect for shareholder meetings on or after February 1, 2009. Contact RiskMet- Takeover Fears rics Group at www.riskmetrics.com. Once the financing markets recover, depressed stock prices may lead to increased hostile takeover Background and Introduction activity. The mere threat of a hostile takeover can Each year, RiskMetrics Group undertakes an disrupt a target’s employees and damage the tar- extensive process to update the policies that in- get’s business even if a raider withdraws. Appro- form its proxy voting recommendations. Our priate change of control employment agreements commitment is to make our policy formulation and other measures can help mitigate these con- process open and transparent, so that all members cerns. Ideally, companies should establish suitable of the financial community—including our insti- arrangements in advance of a hostile bid to ensure tutional investor clients and corporate issuers— a stable and dedicated employee base. understand the foundations of our benchmark policies and proxy voting recommendations. Our bottoms-up policy formulation process collects feedback from a diverse range of market participants through multiple channels: an annual Policy Survey of institutional investors and corporate issuers, roundtables with industry groups, and ongoing feedback during proxy season. Each year, the RiskMetrics Group Policy Board uses this input to develop draft policy updates on the most important governance issues, which are then published for an open review and comment period. This year, comments were posted verba- tim to the RiskMetrics Policy Gateway, in order to provide additional transparency into the feedback we have received.

This document summarizes the outreach pro- multiple markets as well as general principles in cess and explains the key changes made to Risk- treating governance issues in an increasingly glob- Metrics Group’s U.S., Canadian and Internation- al investment environment. al benchmark corporate governance policies. The For the first time, corporate issuers were invited full text of the updates is available through the in 2008 to participate in a parallel version of the RiskMetrics Group Policy Gateway at www.risk- United States policy survey. Invitations were sent metrics.com/policy. to a broad range of issuers in the United States— contacts were drawn from standard industry 2009 Policy Formulation Process databases of corporate governance and investor Throughout the year, RiskMetrics Group’s gov- relations staff at U.S. corporations. The issuer ernance research team identifies emerging corpo- survey contained close to identical versions of all rate governance issues as it analyzes proxies and questions in the institutional survey that would be interacts with investor clients, shareholder pro- applicable to corporate issuers. ponents, and corporate issuers. In addition, the Over 700 total responses were received for the research team collects data on meeting agendas, surveys. On the institutional side, 317 institution- vote results and corporate governance practices al investor responses were submitted, representing which together provide insight into how industry a total of 200 unique institutions (approximately stakeholders are approaching these governance 12% of RiskMetrics’ governance clients). On the issues. corporate side, 390 corporate issuer responses The Policy Board assembles these analyses in were received. identifying specific policy topics where updates to The institutional respondent profile is close to RiskMetrics’ benchmark policy should be further the overall profile of RiskMetrics’ governance investigated. These topics are incorporated into client base, with slightly over half being invest- questions in an annual Policy Survey, which is in- ment managers or mutual fund managers, and tended to assess the range of investor and issuer the balance divided between pension funds and opinion on these topics. endowments, insurance companies, banks and This year’s survey was fielded in July and Au- investor groups. The corporate responses repre- gust, 2008, after the end of the U.S. proxy season. sented a broad range of issuers across the market The survey contained policy questions on Board, capitalization and industry sector spectrums, as Compensation, Audit, Corporate Responsibility well as some corporate advisors and issuer orga- and other corporate governance topics. nizations. Institutional investor input was solicited In addition to the policy survey, RiskMetrics through five regional surveys: solicited feedback on specific, high-profile topics from industry constituents: • United States; • Several institutional investors and consul- • Canada and Latin America; tants participated in a telephonic roundtable on resetting performance goals and repricing • United Kingdom; of stock options on October 2, 2008. • Europe, comprising France, Germany, Ire- • Compensation topics were also the subject of land, Portugal, The Netherlands, Scandina- discussion with twenty investors and issuers via (Sweden, Norway) and Russia; in conjunction with the Council of Institu- • Asia-Pacific, comprising Australia, Hong tional Investors Fall meeting on October 5, Kong, Singapore, South Korea and Japan. 2008.

Institutional investors were also invited to par- • As part of RiskMetrics’ Governance Ex- ticipate in a general international survey which change program, investors, directors and sought investor opinion on issues that apply to corporate issuers discussed the independent

chair issue on a webcast on September 16, against compensation committee members, has 2008. been expanded to include:

• Share buybacks and discharge of directors • new change-in-control arrangements that were the subject of a governance roundtable include tax gross-ups on excise payments at RiskMetrics’ European client conference triggered by severance (“golden parachute”) on September 16, 2008. payments,

The Policy Board uses the feedback collected • tax gross-ups on executive perks, through the policy survey and roundtables to in- • modified “single-trigger” change-in-control form the development of draft policy updates that provisions that allow an executive to receive also incorporate findings from academic research a change-in-control payment upon voluntary and RiskMetrics’ own analysis of corporate gov- resignation, and ernance data. Prior to being finalized, the most important • payment of dividends or dividend equivalents policy updates are released for an open comment on unearned performance awards. period, where all market participants are invited In the RiskMetrics 2007-2008 Policy Survey, to provide input on the proposed new policies. a vast majority (76%) of respondents consid- This year, thirteen draft policies were released to ered excise tax gross-ups to be problematic. In the public on October 14, 2008 on the RiskMet- addition, our analysis of estimated change-in- rics Group Policy Gateway, with a broadly an- control payments for the S&P 500 companies, as nouncement via press release. During the three- disclosed in 2008 proxy statements, found that week comment period that followed, about 20 companies with tax gross-ups have significantly different organizations submitted 58 separate higher change-in-control payouts. Potential pay- comments on the policies. Most comments were outs for named executive officers at companies submitted by corporate issuers and issuer groups, providing tax gross-ups averaged $72.5 million, and were concentrated on the U.S. draft policy nearly $30 million higher than for companies not updates. providing tax gross-ups. Only $12 million of the This feedback, including results from the Policy difference is due to the amount of the gross-up, Survey, draft policy updates, and comments re- indicating that the gross-up may be prompting ceived, are all available on the RiskMetrics Group higher change-in-control payments. Policy Gateway at www.riskmetrics.com/policy. Commenters on the draft policy update noted Summary of Policy Updates that tax gross-ups may have a legitimate use in equalizing payouts across similarly-situated ex- The highest profile updates are summarized be- ecutives who may have a different exposure to low. The full text of the U.S., Canada and Inter- the excise tax, based on disparate pay or option national policy updates is available through the exercise history. Given strong investor opinions RiskMetrics Group Policy Gateway. about gross-ups and the evidence that they inflate change-in-control payouts, the Policy Board has United States & Canada Policy included new agreements that include excise tax Updates gross-up provisions, as well as all gross-ups on Poor Pay Practices (U.S. & Canada) executive perks, in the Poor Pay Practices policy. In order to clarify RiskMetrics’ treatment of RiskMetrics recognizes the momentum towards excessive perks such as personal use of corporate improving executive pay practices and has revised aircraft, security systems, and car allowances, the its compensation policies accordingly. The U.S. updated policy establishes guidelines for evaluat- Poor Pay Practices policy, which identifies pay ing whether a given perk is excessive. In response practices that would prompt recommendations to issuer comments that the fixed dollar thresh-

olds proposed in our draft updates were inflex- times the company’s size, measured by revenue, ible, the new policy provides guidance for case- assets or market capitalization as appropriate. by-case analysis of the value of perks. The minimum number of companies in the peer In Canada, where compensation-related disclo- group has been reduced to 8, and for very large sure has substantially improved and will provide companies, peers may be drawn from a wider shareholders with similar information as available industry-sector or index pool, in order to create a to U.S. shareholders, RiskMetrics is introducing a group of reasonably similar companies. Poor Pay Practices policy. The updated policy, for As we look to the critical issues facing com- members of the S&P/TSX index, will recommend panies and investors in evaluating executive pay withhold votes for compensation committee this coming year, we recognize the unique cir- members at companies with poor pay practices, cumstances that companies face in assessing the and recommend against equity plans that are a market for corporate talent while providing con- vehicle for poor pay practices. Poor pay practices sistent, meaningful information to our investor are defined along similar lines as the U.S. policy. clients. Therefore, we plan to add to our research reports a comparison of CEO pay under both our Shareholder Proposals and “Resetting peer group methodology and the peer group se- & Repricing” Equity Plans lected by the company. The updated peer group methodology, as indicated in our policy updates, RiskMetrics is also aligning our policies on will be released in 2009. The report modification compensation-related shareholder proposals to that will compare RMG’s peer group to the com- the practices outlined in the U.S. Treasury’s rules pany’s peer group will be released at a later date. under the Emergency Economic Stabilization Act We will continue to provide updates on the time- of 2008. Proposals on “claw-backs” of incentive line for release of the report modification. pay, for example, may now receive support if existing company policy does not meet the practices Harmonization of Performance Tests outlined by Treasury. Proposals seeking holding (U.S.) requirements for executives receiving stock-based incentives will, similarly, be evaluated with a view Several RiskMetrics policies incorporate an to the risk-incentivizing behavior associated with evaluation of company performance: the Perfor- certain incentives. By the same token, RiskMet- mance/Governance Evaluation for Directors, Pay rics will not view market deterioration, in and of for Performance, and the policy for evaluating itself, as an acceptable reason for companies to Independent Chair (Separate Chair/CEO) Share- re-price stock options or reset goals under per- holder Proposals. formance plans. Given the extraordinary levels of The 2009 updates harmonize the measure of market volatility, RiskMetrics is also using 400- performance across these policies, and introduce day stock volatility in measuring the cost of eq- a relative basis for assessing performance. Under uity plans. the new policies, poor performance for Russell 3000 companies is defined as below-median to- Compensation Peer Groups tal shareholder returns, relative to industry peers RiskMetrics Group’s proxy research reports for or the index as a whole, for one- and three-year annual meetings of Russell 3000 companies dis- periods. play the pay of CEOs relative to their peers. For This update reflects a broadly-held belief among 2009, the methodology that we use for construct- investors and issuers that relative performance ing peer groups has been changed, in response to measures are more meaningful, especially during both institutional investor and issuer feedback. a period of high market volatility. While some is- Under the new methodology, company size will suers commented that TSR is one of a variety of be a key determinant in constructing these peer metrics that might be used to assess performance, groups, with peers falling between 0.5 and 2.0 TSR is the single most tangible indication of re-

turn on investment from a shareholder perspec- a combined role, leading us to incorporate a relative. In addition, the performance measure is tive performance measure into our policy. one input into RiskMetrics’ broader analysis of a company’s practices and performance, not a Poor Accounting Practices (U.S.) single bright-line test. The updated Poor Accounting Practices policy Independent Chair Shareholder provides additional transparency into the issues Proposals (U.S.) that would trigger a deeper, case-by-case analysis of accounting practices, as well as the factors that As in prior years, RiskMetrics will generally RiskMetrics would analyze in making a recom- recommend in favor of shareholder proposals re- mendation against either the audit committee or quiring that the Chair’s position be filled by an the full board. independent director, unless the company main- Several commenters on RiskMetrics’ draft tains a counterbalancing governance structure policy update objected to including regulatory with an independent lead director and established investigations as a potential factor for triggering governance guidelines, does not exhibit poor TSR greater scrutiny over accounting practices. In the performance, and has no problematic governance Policy Survey, investors identified misapplica- or management issues. tion of GAAP and material weaknesses in Sec- Updates to this policy in 2009 include a harmo- tion 404 disclosures as the most likely to prompt nization of the performance measure with other a vote against either board or audit committee, policies and a clarification of what constitutes and these issues, along with fraud, are specified problematic governance and management issues. as poor accounting practices that would trigger a The updated policy also removes a requirement deeper analysis. to formally disclose a comparison of the duties of The policy further specifies that this analysis lead director and chair and a rationale for com- will take into account the severity, breadth, chro- bining the roles. nology and duration of the accounting practices This policy drew many comments from the is- in question, along with the company’s efforts to suer community. Several noted that only 38% of remediate and correct these practices. investor respondents to the Policy Survey support- The policy has been also been updated to rec- ed separating the roles. In fact, 67% of investor ommend against audit committee members in respondents indicated that a combined role was ei- the case of an adverse opinion from auditors on ther generally unacceptable or was acceptable with the company’s financial statement. While several good governance provisions and a satisfactory commenters on the draft update recommended rationale. Indeed, a majority of issuer respondents that RiskMetrics treat this on a case-by-case (55%) fell into these groups as well. The policy basis, an adverse opinion indicates an inability provides a framework for evaluating whether good of the auditor to resolve accounting issues with governance provisions and a satisfactory rationale company management and represents a failure of for the combined role are present. Other commenters noted that a TSR metric for board oversight. assessing performance was inappropriate, and International Policy Updates referenced academic studies that found a negative correlation between performance and the presence Both share buyback and director discharge of an independent chair. Our review of academic were the subject of white papers by RiskMetrics research has found that the evidence for a correla- Group research analysts released this fall. These tion was inconclusive. However, half of investor papers were, in turn, discussed by RiskMetrics and nearly two thirds of issuer respondents to the Group’s institutional investor clients at RiskMet- Policy Survey identified strong company perfor- rics’ annual European client conference in Lau- mance as a satisfactory rationale for maintaining sanne Switzerland, in September. This research

and discussion informed the policy updates sum- Under the updated policy, RiskMetrics will rec- marized below. ommend against discharge of directors on a case- by-case basis when there is reliable information Share Buyback that the board is not fulfilling its fiduciary duties; RiskMetrics’ Share Buyback policy is being up- for example: dated to reflect client feedback and regulatory de- • a lack of board oversight or board members velopments in the EU, which now allow member operating in private or company interest states a broader range of possibilities with regards rather than in shareholder interest; to share repurchases. The updated policy establishes a maximum volume of 10% of outstand- • the presence of legal actions that aim to hold ing shares (15% in the U.K.), with a cap of 10% the board responsible for breach of trust, be- of shares to be kept in treasury, and a maximum yond the fiscal year in question for discharge; duration for repurchase authority of 18 months. or RiskMetrics will continue to recommend against • the presence of egregious governance issues repurchase proposals that are against the inter- where shareholders will bring legal action est of shareholders, e.g., can be used for takeover against the company or its directors. defenses or can be abused. The intent of this update is to provide an ad- Discharge of Directors ditional mechanism for shareholders to express RiskMetrics has updated its Discharge of Di- their discontent with directors—to provide a rectors policy for European companies to reflect cautionary “yellow card” to directors instead of a transformation in shareholders’ willingness to a “red card” signifying shareholders’ desire for exercise their rights. The discharge resolution is a removal of directors. prominent, but undervalued, tool for sharehold- Policy updates are available at www.riskmet- ers to communicate with directors. rics.com/policy.

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