Comment: Corporate responsibility and US class action lawsuits

December 2002

by Jon Entine

Many are suing for corporate responsibility in the US, but is it the best way to go about bringing change? Jon Entine investigates

There’s a new take-no-prisoners sheriff in the corporate responsibility arena in the United States. Class action lawyers who took $240 billion out of the coffers of Big Tobacco (and silk lined their own pockets in the process) are now turning their sights on the burgeoning corporate scandals, taking dead aim at Wall Street.

Is this a good or bad turn of events?

It’s now axiomatic that corporations must implement tighter accounting standards, reform governance practices and reexamine executive compensation principles. But how do we get from here to there? And beyond the vague generalities that such reforms promise, where exactly are we trying to go?

The reforms proposed by the Business Roundtable and New York Stock Exchange are sensible enough. But it’s hard to figure that any of the high-profile corporate implosions would have been avoided if these reforms had been previously implemented. And it’s dubious whether the congressional legislation factory can generate anything of definitive value. Corporate lobbyists are already working to limit the reach of reform, and anything they miss will almost certainly face the wrath of clever corporate lawyers.

If the carrot of reform seems of limited real value in reining in corporate excess, perhaps the stick of fear might do it – not only the fear of being carted away in handcuffs a la Daniel Kozlowski and John Rigas, but of seeing your company, pay and future promised retirement benefits included, dismantled. At least that’s the argument put forth by a slew of lawyers who specialize in representing investors in securities lawsuits. By recent count, Enron and its executives have been hit by 45 securities lawsuits, Adelphia by 56 and Tyco by 60.

But these actions are not of the kind that heeled the tobacco industry. For years, a class action was the litigation weapon of choice. Plaintiff lawyers could simply allege fraud based on circumstantial evidence and hope to find incriminating information – the smoking email – during the discovery process. But by 1998, Congress all but closed down that avenue. That’s led to some novel plaintiff strategies.

Wolf Haldenstein now pursues what are called “shareholder derivative actions”. It recruits shareholders to in effect “stand in the shoes of a corporation” by claiming what the company cannot or will not otherwise assert because its officers and directors are allegedly the wrongdoers against whom the derivative action is to be brought. Earlier this year, it filed such a suit against Computer Associates, asking for "tens of millions of dollars in damages” and charging that it “double-counted” revenue, used a “secret” layoff to cut costs, and devised an accounting method to disguise an “enormous decline in revenue”. Wolf Haldenstein was among the firms that two years ago successfully sued to force the return of a portion of a $1.1 billion stock award to top CA executives.

To whose benefit?

Socially responsible investing advocates are cautious about embracing these shareholder recovery actions. “There should be accountability for gross negligence and fraud,” George Gay, CEO of First Affirmative Financial Network told me. “But I’m not crazy about suing corporate shareholders to pay back past shareholders.” Moreover, investors often stand to recover very little if the target of their suit – for example, WorldCom – goes under and they find themselves at the back of the bankruptcy court queue.

Thomas Burt of Wolf Haldenstein says these issues are less of a concern. Instead of going after the companies directly, firms now often litigate against third parties – particularly directors and officers who have lots of liability insurance. However, that still doesn’t remove the fairness issue raised by Gay since targeting all board members undoubtedly maims innocents.

William Lerach of Milberg Weiss, point man in the tobacco suits, is pursuing another new strategy by filing in state courts, and on behalf individual investors, including major pension funds such as the California state teachers pensions fund, known as Calpers, in its suit against WorldCom. He’s focusing on supposedly miscreant enablers – financial firms such as Citigroup, JP Morgan, Deutsche Bank, UBS Warburg and others, rather than on the tottering companies, which may end up in bankruptcy. “I told my clients that your chances of real recovery of meaningful money is on the bonds,” Lerach has said. “It so outweighs any speculative hope of recovery on the stock.” Defendants need not be shown to have committed fraud, a tough standard to prove in court, just that they issued misleading financial statements when they underwrote $20 billion in WorldCom bonds.

These new litigation strategies are as welcome as castor oil by corporate executives, who yet hold their collective tongues for fear of a public backlash. But there are real questions whether such suits lead to reform. “These lawsuits are a huge distraction [to corporations and executives] when they hit,” says Michael L. Charlson, with Heller Ehrman White & McAuliffe, which represents companies. Many able directors have voiced concerns about serving for fear they will face liability from events not of their own making. Insurance companies have quadrupled some premiums on corporate director and officer policies.

So should corporate responsibility advocates embrace this new wave of plaintiff litigation? Choose your poison. It’s certainly a messy weapon driven more by money than ethics. Potential defendants represent a potential goldmine for lawyers, who clearly will benefit far more than individual shareholders. “There are efforts by the plaintiffs to expand the number of deep pockets that can be held liable, and [efforts] by the deep pockets to prevent themselves from becoming enmeshed in litigation,” says Joseph Grundfest, a securities law expert at Stanford University Law School. “All of these strategies can be understood in terms of profit maximisation. That’s the way litigation works.”

As crude as that conclusion may sound, however, it flows from a deeper reality. Without real incentives – in this case fear of losing money or the enticement of winning some – changes (or reforms) rarely happen.

Jon Entine is scholar-in-residence at Miami University (Ohio) and adjunct fellow with the American Enterprise Institute in Washington, DC. Jon is also an award-winning freelance journalist.

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