The Stakes are Soaring in Shareholder Lawsuits
from
July/August 2002
by Randy Myers
Now it gets scary.
Any lingering perception that corporate board service was a synonym for sinecure disappeared for good on October 17, 2001, when the first of more than 40 shareholder lawsuits was filed against officers and directors of Enron Corp. Sure, most directors have always taken their jobs seriously. Yes, director liability has been an increasingly hot button for years. And yes, the special responsibilities of audit committees have been hammered home by a raft of new regulations laid down by the Securities and Exchange Commission and the major stock exchanges. But Enron changes everything. If some directors had come to feel they were operating in a fishbowl, they now see that the bowl is under a spotlight and surrounded by suspicious shareholders, worried employees, angry legislators, thirsty plaintiffs’ attorneys, and regulators eager to redeem their reputations. Enron revealed enough flaws in the public accounting system to keep Congress working overtime for years—and to keep corporate directors awake at night.
All this comes when the very nature of shareholder litigation is changing, with material implications for corporate defendants. For years, class-action lawsuits were driven by plaintiffs’ attorneys representing mostly small shareholders. Now institutional investors are stepping forward to serve as lead plaintiffs, presenting corporate defendants with sophisticated adversaries that bring substantially deeper pockets and bigger grievances to the table. While dozens of small investors filed class-action suits against Enron, for example, the federal judge overseeing those cases, which have since been consolidated, anointed the University of California as lead plaintiff. The school claims to have lost $141 million from its pension fund as a result of Enron’s meltdown. At least six other institutional investors, including state pension systems in Florida, New York, and Washington, had been vying for lead-plaintiff status.
“The landscape is going to be a little more treacherous from here out,” warns Charles Elson, director of the Center for Corporate Governance at the University of Delaware. “When you have an institutional plaintiff, the odds of a quick and easy settlement probably go down a bit.”
It is a chilling new landscape, and one that could make it harder than ever to keep board seats filled with qualified directors.
“The smaller companies, the start-ups and so forth, won’t have a difficult time recruiting, because the people they’re going after are in their late thirties or early forties, perhaps looking to serve on their first board, and God, they want to be a director,” says Ed Archer, managing director of Pearl Meyer & Partners, an executive-compensation consulting firm in New York City. “But the early-to-mid-sixties retired CEOs are going to be careful where they go, because of the reputation they have built over the years. They really don’t want to put that at risk.”
Roger Kenny, managing partner of New York City-based Boardroom Consultants, a search and advisory firm, agrees. “It hasn’t been easy to get the people you want to sit on boards anyway, for a whole host of reasons,” he says. “But the Enron debacle adds another dimension.”
Nevertheless, Kenny says, the fear factor doesn’t approach the mood among board members during the savings-and-loan crisis of the 1980s, which led to thousands of S&L directors’ being sued by the Federal Deposit Insurance Corp. That may be, but shareholders themselves have never seemed more upset and wary. Stephen Cutler, head of enforcement at the SEC, said in a February speech that during January the SEC’s Enforcement Complaint Center received an average of 525 e-mails per day from investors and corporate employees tipping the agency to possible securities-law violations, up 45% from the daily average in 2001. “There seems to be a heightened sense of passion concerning accounting claims,” agrees attorney Robin Harrison, a partner in the Houston firm of Campbell Harrison & Dagley. He is one of the attorneys representing Enron employees who are suing the company over losses in their 401(k) plan.
Elson warns that it’s too early to predict just how lasting the fallout from Enron will be on board recruiting efforts. But he concedes that it will make the task more difficult for some time. “Unless [prospective directors] have a very clear set of expectations,” he says, “they’re entering into a very dangerous zone where it’s unclear specifically what their obligations and responsibilities are with respect to liability avoidance.”
That’s true of current board members too, as they suddenly find themselves wondering what they might not know about the companies they serve, how they can find out, and what the potential ramifications might be. If the board of Enron, the fifth-largest company in the country, could be lulled into missing the accounting problems that led to its downfall, the thinking goes, almost any board could be at risk of getting hit by nasty surprises.
“Certainly there is a process of examination taking place concerning some of the Enron problems, to make sure none of those problems exist at other companies,” says Jerome York, chairman, president, and chief executive of Micro Warehouse Inc. York serves on the audit committees of the Apple Computer and Metro-Goldwyn-Mayer boards and on the compensation committees of the Metro-Goldwyn-Mayer and MGM Mirage boards. Some companies are already making preemptive moves to ward off potential problems. Apple, for instance, joined a small but growing number of companies in February when it announced that it was formally banning its auditors from performing non-financial consulting services for the company. Many corporate governance experts have theorized that Enron’s auditing firm, Arthur Andersen, found it difficult to rein in some controversial accounting practices because it didn’t want to jeopardize lucrative consulting contracts with the client.
Directors have been seeking the advice of outside counsel to find out whether the Enron debacle has created new risks or responsibilities for them. On an absolute basis, the answer has generally been no: Directors already have broad duties of care and loyalty that endow them with substantial and wide-ranging responsibilities, as well as corresponding liability. Any truly new responsibilities will come only with new legislation or regulations, suggests attorney Joseph Del Raso, a partner in the commercial department at the Philadelphia-based law firm of Pepper Hamilton. Such legislation might be passed; no fewer than 10 congressional committees are investigating the Enron affair, and legislators on both sides of the aisle have proposed new laws aimed at preventing some of the problems facing Enron shareholders. A number of bills, for example, would restrict the use of company stock in 401(k) retirement savings plans. The 401(k) accounts of Enron workers were decimated last year because they were heavily invested in Enron shares that fell from a high of more than $80 each to under a buck.
Without question, many board members—especially audit committee members—are viewing their responsibilities in a fresh and more discerning light. Donna James, executive vice president and chief administrative officer of Nationwide Mutual Insurance Co. and a board member on the audit committee of apparel manufacturer Intimate Brands, echoes a common sentiment among directors. “I do have a greater appreciation for the complexity of the role, especially serving on the audit committee,” she says. “Enron is a sobering reminder of why we are asked to serve and what we are expected to do.”
Directors who do forget can expect a quick wake-up call from shareholders. According to National Economic Research Associates Inc. (NERA), an economic analysis and consulting firm frequently hired by corporate defense attorneys, shareholders filed federal class actions against 498 companies in 2001, up from 223 the prior year and a previous high of 269 in 1998. As has long been the case, the Second and Ninth Circuit federal courts were by far the busiest in the country with such litigation; the Second Circuit, which includes New York and Connecticut, heard 344 of last year’s cases, while the Ninth Circuit, which includes California, dealt with 61. High-tech companies were sued most often last year, accounting for 237 of the lawsuits in which NERA was able to identify the defendant’s industry.
Among the most common triggers were mistakes in securities-offering prospectuses and erroneous or misleading corporate statements that led to financial loss for shareholders. Last year 306 cases were related to initial public offerings—lawsuits that targeted IPO underwriters but also named their stock-issuing clients. Those complaints generally allege that during the frothy stock market of the late 1990s, underwriters allocated shares in hot IPOs in exchange for excessive and undisclosed commissions, plus guarantees that the buyers would buy more shares in the after market.
While it might seem that a stock market that’s been slumping since 2000 would make it harder for shareholders to attribute a declining stock price to securities-law violations, plaintiffs’ attorneys don’t see it that way. In fact, suggests attorney Ed Labaton, a partner in the New York City-based law firm of Goodkind Labaton Rudoff & Sucharow, “maybe what happens in a declining market is that some of the accounting irregularities come out into the open that otherwise might have been hidden by rising stock prices.”
Also working against corporate defendants are numerous federal circuit court decisions of the past two years regarding pleading standards in securities-law cases. The Private Securities Litigation Reform Act of 1995 sought to make it harder to bring securities-fraud cases by requiring stronger evidence that defendants acted with “scienter” (knowledge) that they were violating the law. In a 1999 ruling upholding the dismissal of a case against Silicon Graphics (which had been accused of issuing misleading statements to inflate its stock price while company insiders were selling shares), the Ninth Circuit Court of Appeals further raised the bar. The court interpreted the 1995 act to mean that plaintiffs must show defendants acted with “deliberate recklessness,” an exceedingly high standard that appeared to set a new de facto benchmark for scienter. Since then, however, other circuit courts have shunned that definition, more commonly requiring that plaintiffs merely demonstrate circumstantial evidence of recklessness or the motive and opportunity to commit fraud.
Throw these developments into the hopper along with the Enron case, and corporate directors’ chances of being sued over allegations of corporate malfeasance are greater than ever. The emergence of institutional investors as plaintiffs makes the environment even dicier.
“The fact that institutions have shown a real interest in these cases—and are parties with real losses—has resulted in larger settlements and better decisions,” says Labaton, whose firm was lead counsel in a class action led by the Connecticut Retirement Plans and Trust Funds against Waste Management Inc. Waste Management had been sued over charges of accounting irregularities that caused it to restate its earnings twice in 1999, prompting a steep decline in its stock price. Subject to court approval, that case was closed with a $457 million settlement last year, the third-largest on record.
With the rise of the institutional plaintiff, directors of publicly traded companies can now take less solace in the conventional wisdom of yesteryear, which held that class-action shareholder lawsuits were as much lawyer-driven raids on corporate coffers as they were efforts to recoup real damages suffered by real shareholders. In that environment, attorneys specializing in such cases actually kept rosters of compliant small investors—professional plaintiffs—on whose behalf they would file their suits. Not surprisingly, it was the lawyers, not the plaintiffs, who directed the litigation and the settlement negotiations—most significantly, the attorneys who ran the show as lead counsel once their clients were chosen as lead plaintiffs by the courts.
The 1995 litigation act sought to destroy the professional-plaintiff phenomenon by specifying that a lead plaintiff should not be the shareholder who filed suit first, but rather the one who had suffered the greatest damages. Seven years later, the law finally seems to be working. Federal courts are routinely rejecting attempts by plaintiffs’ attorneys to present large groups of unrelated small investors as a single entity deserving of lead-plaintiff status.
Settlements are already going up. Cendant Corp., in a class-action fraud suit led by the California Public Employees’ Retirement System, the New York State Common Retirement Fund, and the New York City Pension Funds, settled in 1999 for a record $2.8 billion to close a case centered on allegations of accounting irregularities at CUC International, one of its predecessor companies, where three former executives had pleaded guilty to inflating profits to meet Wall Street expectations. Ernst & Young, which had been CUC’s auditor, agreed to kick in another $335 million. The next year, 3Com Corp., in a class action led by the Louisiana School Employees’ Retirement System and the Louisiana Municipal Police Employees’ Retirement System, settled for $259 million. That lawsuit alleged that 3Com hid losses at its U.S. Robotics subsidiary while 3Com insiders were selling shares. And early this year, Bank of America agreed to pay $490 million to settle lawsuits related to losses on what it described as a $1.4 billion unsecured loan made in 1997 to D.E. Shaw & Co., a New York hedge fund. The news sent Bank of America’s stock tumbling. Last summer the SEC said the loan should have been characterized as an investment. In contrast, without the precedent-setting Cendant case, the average settlement as recently as three years ago was a mere $12.9 million. The implications should not be lost on corporate legal advisers. “As institutions step in to serve as lead plaintiffs, defense attorneys would be well advised to take their presence very seriously,” says Max Berger, a partner in the New York City-based law firm of Bernstein Litowitz Berger & Grossmann, which served as co-lead-plaintiff counsel in the Cendant case. “Defense attorneys think it’s business as usual, and it’s not.”
In this uncertain environment, plaintiffs’ attorneys say, corporate board members can take a number of measures to prevent shareholder lawsuits or minimize their consequences. Both Berger and Labaton urge directors to be proactive rather than reactive in monitoring management activities. (For more on this subject, see “How to Protect Your Assets,” page 128.) Members of the audit committee in particular should pay close attention to a company’s unaudited quarterly earnings statements before they are released, and should make sure that the company’s outside auditors have given those statements serious review. Board members who aren’t on the audit committee should make sure that those who do serve on that panel are truly independent. And all directors should make sure their companies carry directors’ and officers’ insurance at levels sufficient to protect them. Despite recent sharp rises in D&O premiums, this is no time to be parading about in skimpy coverage.
In short, say Berger and Labaton, question everything. Don’t rubber-stamp fairness opinions. Be wary of allowing auditors to serve as company consultants and thereby compromise their independence. Question even director compensation; check to see if it’s significantly higher than director pay at comparable companies. Directors might also consider taking seminars in corporate governance, such as those sponsored by Charles Elson’s Center for Corporate Governance, Labaton says, especially if they are new to serving on a board or have been named to an audit committee.
Once a company has been sued, say plaintiffs’ attorneys, directors should urge rapid resolution, since drawn-out cases can consume vast amounts of money as well as management time and attention. Berger also advises companies to deal more frankly with their insurance carriers. “I am finding out that companies often come out swinging so strong early in a case, claiming that the lawsuit is frivolous, that their insurance companies take them literally,” he says. “Then, when the company decides that it’s time to settle, the insurance carriers say, ‘Well, if it’s literally a bogus case, why should we pay?’ Companies ought to be a lot more delicate in how they handle their insurance carriers, by honestly pointing out the risks to them.” Labaton says that directors can also consider advising senior management to participate directly in settlement negotiations, to speed a case to conclusion. In the Waste Management lawsuit, for example, the company’s chairman and CEO, Maurice Myers, met face-to-face with Connecticut treasurer Denise Nappier and Connecticut attorney general Richard Blumenthal, and conducted some of the negotiations. That ran counter to conventional wisdom, of course, but attorneys at Goodkind Labaton Rudoff & Sucharow say they believe that it contributed to a quick resolution of the lawsuit, which was concluded 17 months after Connecticut was named lead plaintiff.
With shareholder litigation starting to generate nine-figure settlements with alarming regularity, conventional wisdom may be overdue for an overhaul anyway. Just ask the investors who were counting on Enron’s board to protect their interests.
