Settling for Reform

Call it good governance at gunpoint.

It's a phrase that Pat McGurn, director of corporate programs for proxy adviser Institutional Shareholder Services, has coined to describe corporate-governance reforms won in the settlements of shareholder lawsuits.

As a few recent cases demonstrate, it's a practice that is becoming increasingly common in this post-Enron era. Thanks to an 8-year-old law, more public funds are taking the lead in shareholder suits and demanding more corporate-governance reforms as part of their settlements.

In August alone, at least four companies -- Homestore ( HOMS), DaimlerChrysler ( DCX), Computer Associates ( CA) and Siebel Systems ( SEBL) -- settled significant shareholder suits. Of those, settlements in both the Siebel and Homestore cases included a raft of corporate-governance reforms.

"You're going to see even more of it in the future," says McGurn, whose firm advises institutional shareholders on proxy voting and corporate-governance matters. Whenever a large public fund is involved in a case, it's almost a guarantee the settlement will include some corporate-governance reform, he adds. And such funds have become increasingly willing to file shareholder suits ever since Congress passed the Private Securities Litigation Reform Act of 1995.

Ironically, that act was introduced in part to make it harder for trial lawyers -- and in particular the leading plaintiff firm Milberg Weiss Bershad Hynes & Lerach -- to sue companies. But the result seems to be higher monetary awards in such cases and a greater willingness of pension funds to sue.

The law changed the rules determining who would have control of a shareholder suit. Before its passage, control of a class-action suit went to whoever filed a suit first; after its passage, control went to the shareholder with the largest loss.

As a result, pension funds have been more willing to step up to the plate in such cases, because their large holdings generally mean they get control of the suit. And they place a greater emphasis on corporate governance than the individual shareholders who dominated the suits before the act passed.

In the past, the individual shareholders often lost their investment or didn't have a large enough stake to care about corporate governance, explained John Coffee, director of the Center on Corporate Governance at Columbia University. But "institutional investors want to protect their remaining investment and want to see corporate governance that protects them in an ongoing fashion," he said.

In 2002, the number of federal securities class-action litigation suits climbed 31% to 224 filings from 171 in 2001, according to a report from the Stanford Law Securities Class Action Clearinghouse in cooperation with economics consulting firm Cornerstone Research. That excludes 312 "IPO Allocation" securities class-action filings in 2001 alleging fraud in the IPO underwriting process and more recent "analyst" suits naming analysts and investment banks as defendants.

About 30% of all post-Reform Act settlements through 2002 have involved an institutional investor as lead plaintiff, according to Cornerstone Research. That's up from less than 20% of settlements involving an institutional investor from 1991 to 1994.

In addition, the total value of cases settled and average settlement amount have increased each year since the passage of the Reform Act, according to Cornerstone Research. And Milberg Weiss Bershad Hynes & Lerach was involved as lead or co-lead plaintiff counsel in more than 50% of all post-Reform Act cases through 2002.

Large pension funds were plaintiffs in both the Homestore and Siebel cases. In the Siebel case, settled Aug. 26, the reforms won by the Teachers' Retirement System of Louisiana included limits on director compensation and the addition of a new outside director, with the $10 billion retirement fund having input into that director's selection.

In the Homestore case, settled Aug. 13, the California State Teachers' Retirement System won several changes to the company's board of directors. The company agreed to gradually eliminate staggered terms for directors, ban the use of stock options to pay directors and allow shareholders to directly nominate a director to the board. The settlement also will create a group of independent directors that will meet at least once a year without senior management and nonindependent directors.

The settlements in August came about three months after another significant agreement involving Hanover Compressor ( HC). The most groundbreaking provision of that settlement allows shareholders with more than 1% of outstanding shares to nominate candidates for two new independent director positions.

Among the first securities cases to include corporate-governance provisions in a settlement was the historic Cendant ( CD) suit at the end of 1999, according to McGurn of ISS. In the largest monetary settlement in history, at $2.83 billion, Cendant agreed to get shareholder approval before repricing stock options, ensure that the majority of its board would be independent within two years of final approval of the settlement, and ensure that the board's audit, compensation and nominating committees will be composed of only independent directors.

Such provisions have picked up in popularity in the past couple of years, largely as fallout from the rash of corporate scandals at companies such as Enron and WorldCom.

It's a "post-Enron situation where people are keenly attuned to the idea that corporate abuse is only going to be stemmed by this type of corporate governance," says Bruce Simon, an attorney with the Burlingame, Calif.-based firm Cotchett Pitre Simon & McCarthy, who represented California State Teachers' Retirement System in its suit against Homestore.

Few shareholder suits go to trial; the vast majority are settled first. But it may appear that more are settling recently simply because more were filed in the period after the dot-com and stock market bust in March 2000 and subsequent rash of corporate scandals. Most shareholder suits settle after 2 1/2 years, experts say.

That said, a lawsuit is usually not the first choice -- but rather the last resort --for institutional shareholders to win changes in corporate governance.

"You'd rather be reaching these things through dialogue and the board of directors," said ISS' McGurn.

But he noted that in Siebel's case, the company took an adversarial stance when it faced shareholder measures on expensing stock options and tying executive compensation to performance at its annual meeting in June. (A majority of shareholders voted down the measures.)

"Frankly, it shows these people pick up a lot of interest in reform when a lawsuit is involved," McGurn said. "To me that's a little bit sad. You'd like to see companies and boards doing governance reform because they believe it's the right thing to do."

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