Failed Deals, Bankruptcy and Class Action Securities Fraud in Global Outsourcing:
In re Alcatel Securities Litigation

© 2005 William B. Bierce.   All rights reserved.

        In a pre-Sarbanes-Oxley time, the hypergrowth Dot.Com era disintegrated into "Dot.bomb" implosions.  Reciprocal deal-making in speculative ventures was almost the norm, particularly in telecommunications transport.  The litigation aftermath of failed deals, bankruptcy and class actions for securities fraud is reaching resolution.  This short case study provides a synopsis of some key points of failure in reciprocal transactions, with a focus on telecom. 

    Background.   Alcatel is a French technology corporation.  On October 20, 2000, the company issued a U.S. initial public offering (IPO) for its Class O shares.  This class was 100% owned by Alcatel, but served as a "tracking" stock for the company's Optronics Division.  The IPO raised approximately $1.2 Billion and created additional shares that could be used as currency in mergers and acquisitions.  

    The Reciprocal Deal.  Soon after the IPO, Alcatel announced that it had invested $700 million in its customer, 360networks Corporation.  In turn, the customer agreed to purchase over $1 billion in equipment from Alcatel to create a proposed trans-Pacific fiber-optic network. 

    Announcements to Investors.  When Alcatel's proposed merger with Lucent fell through, Alcatel issued an unexpected announcement to investors that warned of a projected $2.6 billion loss for the second quarter of 2001.  The loss included charges associated with a write-down of goodwill for two acquisitions (Xylan and Packet Engines), a full write-down of the $700 million invested in 360networks and various inventory write-downs.  Allegedly, the announcement downgraded its Optronics Division in light of that unit's "high exposure to the submarine market and the increased lack of visibility and potential delays in large projects, as well as inventory build-ups."  In re Alcatel Sec. Litig, __ F.3d __, NYLJ Mar. 11, 2005, p. 23, cols. 1-4, p. 24, cols. 1-4, at p. 24, col. 3 (S.D.N.Y. Mar. 11, 2005) (Judge Casey) ["In Re Alcatel Sec. Litig."].

    Violations Alleged.  The Alcatel investors claimed securities fraud.  Most of the claims were dismissed because of late filing.  The case is a cautionary tale and reminds us of the interests of investors as key stakeholders in outsourcing, whether as shareholders in global enterprises or as shareholders or bondholders in service providers.

    Recommendations.   The story of Romeo and Juliet brings to mind the aphorism "'T'is better to have lived and loved than to never loved at all."  

    In securities fraud litigation, the love has turned to hate.  So we posit the modern aphorism,  "'T'is better to have solicited investment and warned than to have never solicited investment at all."   

    In short, participants in outsourcing should each refocus on the specificity of their warnings surrounding the risks of outsourcing and other strategic relationships, the nature and risks of the issuing company's supply chain of suppliers and customers, and the particular risks in the industry.  The generic warnings might not be sufficient, so constant updating may be appropriate, even without considering the special certification, audit and control issues presented under the Sarbanes-Oxley Act of 2002.

    Service Providers.  

    Reciprocal Dealings and Joint Ventures Pose Special Securities Risks.   Typically, the service provider's investors are the ones with a securities fraud claim.  To be put on notice to inquire further, the service provider's investors need to receive a storm warning of the seriousness of a material problem that could affect an ordinary investor's decision to buy, sell or hold the securities of the service provider.  In the case of reciprocal business dealings and joint ventures between service providers and their enterprise customers, the standards of disclosure are heightened because the materiality is heightened: a bankruptcy by the enterprise customer (as in the case of WorldCom for EDS or in the case of 360networks for Alcatel).  

    Designing and Planning for Investor Notification.  Service providers should therefore consider the following prudent business practices:

• Interdependencies: warnings to investors whenever they enter into reciprocal business dealings or joint ventures with customers, to identify the mutuality of commitments and dependencies for success, particularly specific risks of such dependencies.
  

• Material Changes: warnings to investors whenever such dealings or ventures give rise to material losses or other material risks of liability.
  

• Keeping the Risks Small: keeping the size and financial value at risk below the "materiality threshold" so that any failure to disclose would not trigger a claim of material securities fraud (or, in cases of a consortium contract with leading enterprise customers in an industry vertical, a claim that the contract restrains trade or otherwise violates competition laws).

    Enterprise Customers. 

    Enterprise customers face questions, as securities issuers, surrounding the viability of their key suppliers.   Best practices to avoid securities fraud claims should be considered.

• General Warnings about Dependency on Suppliers.   It is customary to identify that the issuer is dependent on its suppliers for continuity of business operations.   
  

• Specific Warnings about Limitations on Liability of Suppliers.   It is customary for commercial enterprises to negotiate limitations of liability.   Enterprise customers seek such limitations when they are sellers, and they customarily allow certain limitations of liability to their service providers, subject to unlimited liability for certain key failures by the service provider.   The enterprise customer should provide specific warnings of the risks of outsourcing.  Any disclosure of mitigation measures taken would be in the nature of "comfort" to the investor, which could backfire and render the warning useless.  
  

• Consider Investing in Your Service Providers and Suppliers.  Enterprise customers may have more leverage over a publicly traded service provider if the customer is also a shareholder.  The amount of the shareholding is not as significant as the fact that the enterprise customer can have access to company information for a valid corporate purpose in relation to its decision whether to buy, sell or hold the shares.  Being a shareholder gives the enterprise customer a seat at the table in the judicial selection of the most representative shareholder to prosecute any shareholder class action.  And it permits the shareholder to opt in or opt out of the securities litigation, which could be useful in governing the personal and corporate relationships as customer.
  

• Negotiate a Good Contract.   A solid outsourcing contract, accompanied by effective contract administration and relationship governance, makes a difference.  In-house counsel not experienced in the art of outsourcing should hire specialized lawyers.   Reliance on consultants to process legal issues may be courting investor inquiry 

Further reading:

Securities Law Summary for Outsourcing: Securities Frauds by Enterprise Customers or their Service Providers
Class Action Fairness Act of 2005
Litigation in Outsourcing
Failed Deals