Caremark Charged with Breach of Duty

Top News, January 26, 2007

Investors allege that Caremark executives agreed to a low-ball bid in exchange for indemnification against options-backdating charges

By Robert Berner

Investors in Caremark Rx (CMX) have filed suit against the company's top management and directors charging that they accepted an inadequate takeover bid from CVS (CVS) in large part because the deal protected them from charges of improper backdating of stock options.

The class action, brought by two pension funds in Louisiana and Pennsylvania, was filed in state court in Delaware on Jan. 5. It comes as an investment advisory group told BusinessWeek that it had confronted Caremark management with trading data that strongly indicated improper backdating by Caremark directors, in addition to management. CtW Investment Group, which advises union pension funds, contends such backdating would compromise the board's independence, including the board's decision to back management's rejection of a higher-priced offer from Express Scripts (ESRX). "The board's recent decision to endorse an inadequate merger proposal from CVS exacerbates our concern that the board is not acting in the best interests of Caremark shareholders," CtW said in a Dec. 21 letter to Caremark, which was reviewed by BusinessWeek.

Competing Suitors

Caremark came under the cloud of the growing backdating scandals last May when it disclosed it had been subpoenaed by the Justice Dept. and the Securities & Exchange Commission as part of a multicompany investigation. The same month, investors in state court in Tennessee filed suit charging executives and some board members with backdating. A Caremark spokesman said Thursday that an internal investigation by the company found no evidence of backdating by executives or the board. The Justice Dept. wouldn't comment.

Against this backdrop, Caremark and CVS announced the deal in November in which the drugstore chain would acquire the pharmacy benefit manager in a stock-for-stock transaction valued at about $21 billion, a price that was below the company's market capitalization the month before. Rival benefits manager Express Scripts followed with a $26 billion cash and stock offer, but Caremark rejected the competing bid on a number of grounds, including that such a deal between two rivals might not win approval from antitrust regulators. Though CVS sweetened its offer in response, it still remains below Express Script's. Caremark shareholders will vote on the deal Feb. 20.

The Delaware class action alleges that indemnification language in the CVS merger agreement is so broadly worded that none of Caremark's executives or directors would be personally liable for any potential legal repercussions from improper backdating, should it be uncovered. In fact, says Gerald Silk, a New York lawyer representing investors in the case, CVS would take on the liability.

Not without Indemnity

The suit charges that Caremark's top executives and the board were willing to sell the company at no premium in part to get the broad indemnity that would cover any potential backdating transgressions. "Conversely," Silk adds, "CVS was willing to give such broad indemnity because it believed it was purchasing the company at such a bargain price."

A Caremark spokesman declined to respond directly to Silk's accusation. The spokesman said such indemnification clauses are customary for Delaware incorporated companies and the new clause was just a continuation of "existing indemnification provisions applicable to Caremark directors and officers." He declined to elaborate. John Amorosi, a New York lawyer representing CVS, says the similar indemnification language is included in most merger agreements and that backdating wasn't even considered when the "clause was negotiated."

A CVS spokeswoman says the company doesn't believe that Caremark has a backdating problem. She added that CVS has "complete confidence in its management and board."

Fortunate Patterns

CtW in its Dec. 21 letter addressed to one director who sat on the audit committee, said that in addition to executives, its analysis of option-granting patterns at Caremark indicates a "high probability" that a majority of Caremark's nonexecutive directors received backdated stock options as compensation between at least 1997 and 2001. Backdating occurs when an option's exercise price, instead of being set on the grant date, is backdated to a point when the stock price was lower. That way the option is "in the money" the day it is actually granted. In trying to determine backdating, analysts look for patterns of stock prices falling in the days before the grant and rising afterwards, indicating the grant date occurred during a trough, a statistical improbability if such timing is common.

On Mar. 8, 2000, for example, six of Caremark's nonexecutive directors received options grants of 25,000 shares apiece, says Richard Clayton, head of research at CtW. The shares posted a 58% percent price appreciation over the next 30 days. Only on eight other days in 2000 did a Caremark stock show a larger 30-day gain, Clayton says, citing the improbability that directors could be that lucky in picking that date.

CtW's letter to the Caremark audit director includes two tables showing similar trading patterns of options granted to the top four executives and six directors. Michael Garland, a spokesman for CtW, said if directors and executives were both receiving the benefit of backdated options as the analysis suggests, it is questionable whether the directors could exercise independent judgment in assessing the CVS acquisition offer.

In a letter Caremark wrote back to CtW on Dec. 27, Caremark said, "we believe our compensation practices, including those relating to the granting of stock options, are conducted and disclosed in accordance with applicable laws and regulations." It continued, "We take very seriously our disclosure obligations under applicable securities laws and regulations, and we devote significant time, attention, and resources to complying with those obligations." Caremark's spokesman declined to elaborate.

Berner is a correspondent for BusinessWeek in Chicago.