While shareholder lawsuits show no sign of abating, the recent settlement of a class-action suit against Cendant Corp. may represent a sea change in securities litigation. Yet that change has less to do with the unprecedented size of the settlement than with the fact that institutional investors replaced plaintiffs' attorneys as the driving force in the case. And despite the huge damages involved, it's welcome news to corporate risk managers that institutions called the tune. Reason: Shareholders, unlike plaintiffs' attorneys, have less interest in bringing a company to its knees.
That's not to say investors aren't interested in big damage awards. On December 7, New York-based Cendant, a marketing and franchising firm, agreed to pay 440,000 shareholders $2.85 billion to settle a suit that stemmed from fraud committed by executives at CUC International, which merged with HFS International to form Cendant in 1997.
The payout is more than 10 times the size of the next-largest shareholder recovery — a $220 million settlement at Waste Management Inc. last year. And according to lawyers for the California Public Employees' Retirement System (Calpers), one of three institutional investors serving as lead plaintiff in the suit, the payout (along with the $335 million recovered from CUC auditor Ernst & Young) will cover an unusually large 37 percent of the losses suffered by shareholders after Cendant announced it had discovered "accounting irregularities" at CUC. As it turned out, those represented some $500 million in fake revenue (see "Hear No Fraud, See No Fraud, Speak No Fraud," October 1998).
But as big as those damages are, they stop well short of driving the company out of business. Indeed, the institutional investors and their counsel hired investment bank Lazard Freres to analyze Cendant's cash flow, financial position, and insurance coverage to determine exactly what the company could afford to pay. "We needed to balance the long- term viability of the company with its short-term ability to pay," says Max W. Berger, counsel in the class action for Calpers, as well as for the New York Common Retirement Fund and the New York City Pension Funds. That's more consideration than the class-action bar would likely show.
A Broad Agenda
Unlike plaintiffs' attorneys, investors like Calpers, which still owns a large stake in Cendant, have an interest in seeing the company recover. As part of the settlement in this case, Cendant management agreed to implement the broadest agenda of corporate-governance changes that any company has ever agreed to as part of a shareholder securities suit (see "Playing by Investors' Rules, at the end of this article). The changes will increase the independence of the Cendant board and its key committees, and force the company to seek shareholder approval to reprice the stock options of corporate managers.
"We argued that the more confidence [the settlement] instills in the investment community, the more it would enhance shareholder value," says Berger. "The company agreed."
Granted, with what Cendant CEO Henry Silverman called "a tobacco-like liability" hanging over its head, management had little choice. "It's called good governance at gunpoint," says Patrick S. McGurn of Institutional Shareholder Services. With institutional investors, rather than plaintiffs' attorneys, holding the gun, corporate-governance issues may become a more common part of shareholder litigation settlements. Up to this point, however, few institutions have thought it worth the time and effort to get involved with litigation. The successful outcome of the Cendant suit may change that. And to the extent that governance changes substitute for even larger damages, the Cendant settlement may have a silver lining.
In fact, the Cendant settlement (a hearing on it is scheduled in a New Jersey District Court on June 28) may be exactly what Congress had in mind when it passed the Private Securities Litigation Reform Act (PSLRA) of 1995. The act was intended to do two things: (1) reduce the number of "frivolous" lawsuits routinely filed by plaintiff firms against companies when their stocks drop significantly; and (2) increase the role of institutional investors in the litigation process, thereby improving the recovery rates of shareholders who legitimately suffer from management fraud, insider trading, and other white-collar crimes that can trigger a plunge in a company's stock price.
To discourage the mad dash to the courthouse that typically follows a drop in a company's stock price, the new rules raised the bar when it comes to proving the merit of a case. Formerly, plaintiffs' attorneys had access to corporate documents and could begin taking depositions as soon as they filed a complaint against a company. That often yielded enough evidence to successfully fight a motion to dismiss a case. Now the lawyers have to come up with far more detail in their complaints about the alleged fraud, and they are not granted discovery privileges until a judge rules on dismissal. "Eventually, we'll see a lot fewer stock-drop lawsuits," predicts an attorney for a major technology firm.
To some extent, it has already worked. While the volatile stock market caused a record 269 shareholder suit filings in 1998, a far larger percentage of cases are being dismissed by federal judges. Studies by the National Economic Research Association show that since passage of the PSLRA in 1995, the percentage of cases dismissed has risen from 12 percent to about 25 percent. And when plaintiffs' attorneys tried to skirt the higher federal standards by filing their complaints in more-favorable state court venues, such as California, Congress closed the loophole by passing another bill in November 1998 that allows defendants to remove state-filed cases to a federal court.
The second aim of the Reform Act was to reduce the power of plaintiff firms in directing securities litigation, by allowing institutional investors to assume the role of lead plaintiff on a case. Before 1995, the first firm to file a complaint would usually be appointed lead counsel. A firm like Milberg Weiss Bershad Hyne & Lerach, of San Diego, which by some estimates accounts for more than half the securities suit filings in the country, filed the complaint first and then went looking for injured parties, usually individual investors, to serve as plaintiffs. The so-called institutional investor provision of the PSLRA attempts to put the horse back in front of the cart by allowing any potential claimant in a shareholder suit to apply for lead-plaintiff status within 60 days of the suit's filing. "The act is all about putting real clients in control of the litigation," says Keith Johnson, general counsel for the State of Wisconsin Investment Board (SWIB), which has served as lead plaintiff in three shareholder suits. The idea is that shareholders with a direct financial interest in cases would do a better job at recovering damages, keeping legal costs down, and bargaining for corporate-governance enhancements.
Certainly, shareholders have to be pleased with the Cendant settlement. The 34 percent recovery of damages is far higher than the 8 to 9 percent for an average settlement. And given that the three pension funds put the legal work up for competitive bid, attorneys' fees, often as high as 30 percent of cash recoveries, are expected to be far less than in lawyer-driven cases. Exactly how much less has not yet been determined.
While some plaintiffs' attorneys argue that institutional investors aren't sophisticated enough to manage a large securities litigation, the outcomes suggest otherwise. SWIB, for example, won court approval to act as lead plaintiff in a suit against Cellstar, a Carrollton, Texas-based distributor of wireless phone equipment. SWIB recovered $14 million, or about 50 percent of the losses suffered by investors when allegedly inflated sales figures triggered a 75 percent drop in the price of Cellstar shares during 1995 and early 1996. Along with the high recovery ratio, Johnson says SWIB saved shareholders more than $2 million in costs by putting the legal work up for competitive bid.
It's clear that many lawyers are not comfortable with institutional investors calling the shots in shareholder suits. Milberg Weiss's William Lerach, for example, dubbed the Prince of Darkness by the corporate community, prefers to work alone. His firm tried to fight the Texas court's appointment of SWIB as lead plaintiff in the case, instead attempting to amalgamate a group of individual investors to play the plaintiff role. Eventually, they submitted an uncompetitive bid, Johnson says. "When we solicit proposals, it's easy to tell which law firms are open to being in client-directed litigation and which aren't," he says.
In the Cendant case, Calpers and the two New York pension funds chose Barrack, Rodos & Bacine and Bernstein Litowitz Berger & Grossmann to serve as co-lead counsel. And according to Max Berger, the partner at Bernstein Litowitz who handled the case, the institutions were actively involved in directing the suit. "They let us be lawyers, but they were definitely hands-on clients," says Berger, whose firm markets itself to institutions for litigation work. The case may not be the first in which institutions took the lead, but given the favorable outcome, it may become a model for large securities class actions in the future, Berger says.
Some, however, are not so sure the Cendant settlement is a sign of things to come. Since the PSLRA was passed in 1995, there have been remarkably few cases in which institutional investors have taken the lead. In part, this is because the courts lack a clear definition of which claimant most adequately represents the interests of all class members. The act suggests that courts choose the party with the largest financial interest. But judges, often heeding the arguments of plaintiffs' attorneys, have also used other criteria to determine the most appropriate lead plaintiff. Institutions desiring the role have, in some instances, been turned away or forced to share it with other claimants and their lawyers.
Also, many institutions simply don't want the bother. "It's often a case of them not wanting to get involved, or not having the resources," says Richard Reinthaler, a lawyer with Dewey Ballantine LLP who defends companies against shareholder suits. Not only do most lack the legal staff to press a fight, but they also aren't keen on upsetting business relationships with defendants and their Wall Street underwriters. Even public pension funds like Calpers, which has dozens of claims every year, have to pick their battles.
For the most part, they choose the large, high-profile cases like Cendant. And for that reason, Reinthaler says that one can't generalize from the case. "Cendant was a slam-dunk winning case," he says. "There was not much risk involved." Indeed, with company management admitting the fraud, and doing the lion's share of the investigation of it, the burden was fairly light on the institutions. This is not the case with most shareholder suits, which are typically against smaller companies and involve smaller claims but require more legwork. "There are simply not enough institutions to go around," says Ann Yerger of the Council of Institutional Investors. Still, the outcome of the Cendant suit is almost sure to motivate more institutions to step up to the plate in shareholder lawsuits.
Of course, CFOs can hardly welcome shareholder suits of any kind. As the Cendant settlement suggests, institutions play hardball with companies that have blatantly damaged their financial interests. On the other hand, CFOs now have more reason to hope that powerful institutional investors will help quash frivolous lawsuits that companies might otherwise settle rather than fight.
At a bare minimum, lawsuits now give the institutions another means to advance their corporate-governance agendas. "This is good for good companies and bad for bad companies," says Johnson. Risk managers across the board may find it pays to wear a white hat.
Playing by Investors' Rules
The $2.85 billion that Cendant Corp. must pay is the largest settlement of a securities class-action lawsuit in history. Along with the huge cash payout, the company also agreed to a broad range of corporate-governance changes that the lead plaintiffs — the California Public Employees' Retirement System (Calpers), the New York Common Retirement Fund, and the New York City Pension Funds — insisted be part of the settlement. Here's what the settlement requires:
- Board independence. A majority of board members must be independent — as defined by institutions such as Calpers and the Council of Institutional Investors — within two years of final approval of the settlement. On April 5, Cendant announced the resignation of two employee directors and the appointment of two outside directors. Two other directors will have left the board after the May 25 shareholder meeting.
- Committee independence. All members of the audit, nominating, and compensation committees must be independent directors. The company will have to replace the entire nominating committee, and replace a former employee on the audit committee.
- Annual board elections. A shareholder proposal for annual election of board directors rather than the current staggered elections of parts of the board is slated for the May shareholder meeting. The company has agreed not to vote against the proposal.
- Shareholder approval of option repricing. When Cendant attempted to reprice the options of CEO Henry Silverman and other managers in 1998, shareholders were appalled. As part of the settlement, Cendant will have to amend its bylaws to require a vote of approval from shareholders before repricing options in the future.