SEC Inquiries and Shareholder Lawsuits: How To Be Above Scrutiny

Four financial restatements, one SEC formal investigation and a $2.47 billion settlement with shareholders -- the numbers look bleak for Nortel Networks. The communication technology company's financial-reporting woes are an extreme instance of an increasingly common equation: Financial restatement and/or SEC investigation equals shareholder lawsuit. * Plenty of other companies may be heading in Nortel Networks' direction. A steady procession of financial restatements over the past few months, many of them related to possible back-dated stock option grants, has dozens of publicly held companies nervously asking one question: Will we see a shareholder lawsuit? * With SEC inquiries trending upwards and the average size of shareholder lawsuit settlements soaring, it pays for public companies to act like Boy Scouts. Corporations that take the "be prepared" motto to heart, legal experts say, are better able to prevent informal SEC inquiries escalating into formal enforcement actions and the shareholder lawsuits that inexorably follow.

The Lawsuit Threat

In 2005, companies listed on U.S. securities exchanges filed nearly 1,300 financial restatements, nearly twice as many as they filed in 2004, according to Glass Lewis & Co., a San Francisco-based research firm that serves institutional investors. The 2005 figure translates to one restatement for every 12 public companies.

Financial restatements arouse the SEC's interest and "almost invariably trigger class-action lawsuits," says David Siegel, managing partner with law firm Irell & Manella LLP in Los Angeles. "It really doesn't matter why or how the restatement occurred -- or, sometimes, even the financial impact of the restatement."

In 2005, 168 private securities litigation cases were filed in the United States -- a seven-year low, according to a study by PricewaterhouseCoopers. However, the average settlement amount increased by a staggering 156 percent over 2004, jumping from $27.8 million to $71.1 million -- and that's excluding the Enron and WorldCom settlements.

While the number of cases filed in 2005 approximates the 10-year average (188 per year), Daniel Dooley, a New York City-based PwC partner who worked on the firm's securities litigation research, believes the current, reduced level of activity "may be the lull before the next storm." Others agree. "I think the decline is short-lived," says Siegel, who expects to see a surge in lawsuits related to the stock options dating issues currently dominating the business pages.

C. Thomas Kruse, a litigation partner with Baker Hostetler in Houston, expects to see more class-action lawsuits filed in state courts. "Every state has a class-action statute," he notes. "I predict you're going to see a lot more state-court class actions as a substitute for the federal-court class actions. And you're going to see more arbitration."

Shareholder lawsuits are becoming decidedly nastier. "We're seeing something that we've rarely seen before, which is a sort of emotional demand by some activist investors," reports Carolyn Kay Brancato, director of The Conference Board Governance Center and Directors' Institute with The Conference Board in New York City. Some shareholders are so incensed by the behavior of their directors and officers that they are seeking out-of-pocket settlements that exceed the company's D&O insurance coverage.