Diamond, shareholders reach unusual deal: class to receive stock

August 21, 2013

On Wednesday, lawyers representing a certified class of shareholders who claim Diamond Foods deceived them about its payments to walnut growers in 2010 and 2011, notified U.S. District Judge William Alsup of San Francisco that they’ve reached a proposed settlement with the company. According to the memo in support of the deal, class counsel at Chitwood Harley Harnes and Lieff Cabraser Heimann & Bernstein were confident that they’d be able to prove at least $270 million and as much as $430 million in damages against the company. Instead, they’re settling for about $107 million, $11 million in cash and the remaining $96 million in Diamond common shares. Yes, that’s right. The supposedly defrauded and disillusioned shareholders in the Diamond class action are being compensated with more stock in the offending company. It’s like that old joke: First prize is a week in Philadelphia; second prize is TWO weeks there.

Class counsel explain in their memo why they had little choice but to agree to the unusual structure of this proposed settlement, which must still be approved by Alsup. Diamond is on the brink of insolvency, with $579 million in debt and just $7.2 million in cash, according to its latest balance sheet. Its primary asset is goodwill and its core walnut business is in decline. Because of the overhang of the shareholder class action, the memo said, the company can’t attract new capital and may even run into problems refinancing its existing loans. There’s some insurance money, the memo said, but the cost of continuing to litigate the case is consuming those funds.

So, according to class counsel, shareholders’ only real shot at recovery was to agree to accept more Diamond equity, and sooner rather later. Otherwise, the class risks driving Diamond into bankruptcy. That would certainly be the outcome, the brief said, if the lead plaintiff, the Mississippi Public Employees’ Retirement System, insisted on trying the case and obtaining a judgment against Diamond. It’s in the best interests of class members, the brief said, not to bankrupt the company and become judgment debtors but to accept $11 million in cash (all that remains of Diamond’s insurance proceeds) and 4.45 million shares of Diamond common stock, the maximum the company can issue without triggering a shareholder vote.

“Unlike the typical settlement where a plaintiff, at least theoretically, can wring as much from the defendant as possible, regardless of the consequences, lead plaintiff in this case had to balance between maximizing the recovery for the class and leaving the company sufficient resources to deal with its future business issues,” the memo said.

I’m sure you’re wondering whether legal fees will also be paid in Diamond stock. The memo said that class counsel will be requesting fees of 14 percent of the settlement fund and $700,000 in expenses, but does not specify whether plaintiffs lawyers want all cash. I doubt that Judge Alsup will approve legal fees with a different ratio of cash to Diamond shares than class members are slated to receive. You may recall that the judge vigorously guarded the interests of class members in the lead plaintiff selection process in this case, in which he ordered the Mississippi pension fund to disclose its counsel selection process and its fee arrangements.

Class action watchdog Ted Frank of the Center for Class Action Fairness told me in an email Wednesday that as long as shareholder lawyers’ fees have the same cash-to-shares ratio as the class’s recovery, the Diamond settlement is “not unreasonable, especially for a cash-poor company facing potentially bankrupting litigation.” Frank said he has seen other class action settlements in which class members receive stock as compensation, although the brief in the Diamond case doesn’t cite any.

One other interesting point for securities class action geeks: The settlement does not include any personal contribution from former Diamond CEOs Steven Neil and Michael Mendes, who were both named as defendants. According to the memo, class counsel weighed the potential upside of going after the former officials’ personal assets against the downside of Neil’s limited assets, the burn rate of litigating against indemnified execs, and the risk that a fraud finding against Neil or Mendes would permit insurers to exclude coverage for the company itself. But the decision was a cinch, the memo said, because Diamond’s insurers said they wouldn’t put up the company’s remaining insurance proceeds unless the class settled all of its claims, including those against the former CEOs.

Alsup has scheduled a hearing for Thursday on a joint motion by Diamond and the class to stay discovery while he considers the proposed settlement. A resolution can’t come soon enough for any of them. According to the settlement memo, when the deal was first struck, in mediation sessions that began in June, the class’s equity stake was valued at $109 million. Since then it has lost $13 million.

I left messages for plaintiffs lawyers John Harnes of Chitwood and Richard Heimann of Lieff Cabraser but didn’t hear back. Diamond counsel Jennifer Bretan of Fenwick & West also didn’t return my call.

(Reporting by Alison Frankel)

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