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Shareholder litigation and the board.

Any company involved in a controversial transaction, business reversal, or just a plain bad quarter is susceptible to a shareholders' suit.

Corporate officers and directors operate in a more complex business and legal environment today than at any time in history. Economic recession and financial restructuring in Corporate America, combined with the advent of the "professional plaintiff," has produced a virtual explosion of shareholder litigation against corporate board members as they try to fulfill their responsibility to disclose meaningful information to the investing public about their company's performance and prospects.

It's like walking a tightrope, balancing the need to communicate fully and effectively about a company's performance, products, and prospects, with the care and caution required by the law. This balancing act is complicated by the disparate goals of corporate communications.

As Harvey Pitt, a noted defense counsel, recently wrote to this clients: "A certain amount of tension exists between the two forms of corporate pronouncements. Formal filings with the Securities and Exchange Commission and/or investors tend to take on somber tones usually associated with the legal profession, while corporate product announcements, press releases, and advertisements, often take a more free-flowing (and perhaps upbeat) form of expression, sometimes unencumbered by any concern for the potential legal liability...."

One slip on the tightrope or overly optimisitc forecast that doesn't materialize and the chances are high that management will face a lawsuit. (See accompanying sidebar for suggestions on minimizing disclosure exposure.)

Shareholder lawsuits continue to grow with no slowdown in sight. There are currently between 500 and 700 shareholder suits pending in the federal court system, according to the editor of Securities Class Action Alert. This uniquely American phenomenon is a growth industry for plaintiff's lawyers, as the number of these suits has nearly tripled in the past three years. A recent study concluded that "virtually every company in every industry faces a significant probability of being used, most likely by one of seven law firms."

The simple reason for the escalation in shareholder litigation is that the monetary incentives to plaintiffs' law firms in bringing these cases are extraordinary high. The law firm representing shareholders in a class action will probably receive one-third of the settlement. These contingency fees compound rapidly in view of the frequency of settlements. Recently, the Economics Consulting Group in Berkeley, Calif., reviewed 330 cases and found that only three went to trial. Most shareholder suits are settled out of court, as is nearly two-thirds of all civil litigation in this country. Alan Shugart, who has faced several suits as the CEO of Seagate Technologies, a Silicon Valley disk drive manufacturer, calls the suit-and-settlement gambit "legalized extortion." Shugart, as quoted in Forbes, said, "They know how expensive it is for us to take our case to court. We're supposed to give them a few million dollars to make it go away."

The largest and most active of these firms is probably Milberg, Weiss, Bershad, Spectrie and Lerach, in New York and San Diego. Some call Mel Weiss, the firm's managing partner in New York, the dean of the plaintiffs' bar. The firm is prosecuting some 150 cases right now, and, based upon any conservative estimate, it is an extremely lucrative business. Weiss offers no apologies, and instead told Forbes that, "We're doing the job that the SEC doesn't have the time or resources to do."

Similar allegations

Any company involved in a controversial transaction, business reversal, or just a plain bad quarter is susceptible to a shareholders' suit brought by one of the "professional plaintiffs." Many of these complaints appear to come fresh out of the word processor, describing similar allegations -- a disclosure of some kind that alleges a material error, omission, or misrepresentation of the company's past or prospective (not just financial) performance, in violation of the federal securities laws, particularly the Securities Exchange Act of 1934. The most frequently used provision is known as Rule 10(b)5, a general fraud prohibition under the 1934 law. Indeed, one well known Philadelphia plaintiff's lawyer is said to have placed "10(b)5 on his Mercedes license plate in recognition of this provision's value to him in cashing in on these suits.

Typically, suits are triggered after a company reports an earnings shortfall with a resulting drop in stock price. The complaint often follows a recurring formula:

-- Here was the stock price last year;

-- Here is what the chairman said in the annual report or the latest analysts' meeting;

-- Here is the stock price now.

There must have been a misrepresentation. To determine the damages, the stock price drop of $10 per share, for example, is multiplied by the number of shares traded in the class period. The sum equals the alleged damages, which can amount to a lot of money if there are a lot of shares outstanding or if the class period is extensive.

Rush to the courthouse

The legal complaint is then rushed to the nearest courthouse, as there is great monetary advantage to the first law firm through the door. These suits are usually class actions due to the high number of similarly situated shareholders allegedly harmed over a shared time frame.

Many of these suits drag on for years in the "discovery" phase and show little substantive merit. Ultimately, however, with such a large number of cases going at any one time, you can think of it as a fishing expedition. If there are enough legal hooks in the water, they are bound to catch something.

A percentage of these suits will undoubtedly uncover some cases of fraud where deliberate wrongdoing has occurred. The majority, however, are instances of rational management decisions which appeared to be sound at the time they were made, but with the advantage of hindsight, often years later, turned out poorly. The protection of the business judgment rule seems to have gotten lost in the process.

Proponents of the system espouse the view that the "widow and orphan" shareowners are protected by this legal process. The result is usually to the contrary, as the lawyers and large institutional holders come away with the lion's share. Joseph Grundfest, a professor at Stanford Law School and formerly a commissioner of the SEC, recently commented about this litigation: "In many cases, perfectly honest people are being forced to pay outrageous sums, simply because they didn't have perfect foresight."

Of course, a primary financial respondent to such lawsuits is often the directors' or officers' (D&O) liability insurer. The major insurers in this specialty line serve as a sophisticated kind of pari-mutuel board, calculating the odds of D&O liability exposure in an ever-evolving legal environment.

Accordingly, adequate coverage in today's dynamic business world is not inexpensive. This volatile line of coverage is difficult to underwrite, and the merger and acquisition boom, fading junk bond market, weak economy, and the savings and loan crisis do not make it any easier. As in any business, the price of the product follows the long-term costs, which in this case is the cost to defend and settle the underlying litigation.

On May 30, 1991, Apple Computer learned what it was like to lose the California court lottery when a San Jose federal jury awarded a $100 million verdict to the plaintiffs based upon a 1982 case alleging misrepresentation in the company's announcement of a new disk drive product. The verdict was entered against two executives, making them personally liable for the award. This verdict has since been reversed by the judge and is under appeal, but not before it sent shivers through the D&O liability insurance industry. The heightened concern was based merely upon the size of the judgment -- nearly $100 million -- but under the prospect that many corporate board members and their legal advisers would be less willing to risk going to court to vigorously defend themselves against future legal challenges, due to the uncertain odds and enormous time and energy required.

Defense of these strike suits is very costly and time consuming for the company and for the individual director or officer. Board members do not like to be deposed by an aggressive lawyer attacking a complicated five-year-old board decision that is supposedly protected by the business judgment rule. Accordingly, irrespective of the events in many instances, the vast majority of these suits get settled before the case reaches a verdict, as does most corporate litigation in this country. Nevertheless, these suits are often difficult to settle because the top plaintiffs attorneys are able litigators with exuberant courtroom skills.

The major underwriters of directors' and officers' liability insurance are odds-makers in this costly gambit. The actual costs extend beyond monetary terms. The threat of personal liability to individual board members combined with the burden of having to devote substantial time to a defense, makes board membership an unattractive risk. In the long run, this escalation in shareholder litigation discourages capable leaders from accepting the opportunity to serve in this capacity, and the results in a regressive corporate tax, with the plaintiff's bar gaining the windfall.

Disclosure Exposure

Disclosure to the investing public is probably the most significant exposure under the federal securities laws as they relate to directors and officers liability. This may be a good time for your general counsel to educate the top members of senior management about this issue. The following suggestions may be useful:

1. Identity Disclosures: Identify the significant sources of disclosure in your company. Obvious sources include Securities and Exchange Commission filings, annual reports, and communications to the press. Other regulatory filings also make disclosures -- for example, those filed with the Food and Drug Administration and the Federal Trade Commission. Other less obvious sources of disclosures include communications with shareholders, securities analysts, and employees.

2. Clarify the Law: Make sure all those involved with the disclosure understand the legal standards applicable to the document. For example, general antifraud provisions preclude any material misrepresentations or omissions. Plaintiffs may allege that a negative news announcement was made well after the news event was in fact known to the company, and was not disclosed in interim press releases.

3. Review Procedure: Examine the procedure for making the identified disclosure. Who drafts it? Do counsel or other necessary experts, such as accountants, review it? Do representatives of affected or referenced departments review it -- for example, the chief of research and development, with respect to a promised new product? These reviews minimize the risk of an erroneous, misleading statement.

4. Manner of Disclosure: The manner in which the disclosure is made may have an impact on its accuracy. The disclosure must be reviewed for completeness. The arrangement of the facts must be clear so that it does not bury key facts. The disclosure of opinions and predictions, rather than simply facts, must be carefully reviewed for accuracy and compliance with regulations addressing such disclosures. Opinions and predictions typically arise with respect to future earnings, asset values, mergers, or other such corporate transactions.

5. Assignment of Responsibility: Your cooperation should have well defined and well understood assignment of responsibilities with respect to various securities law and disclosure issues. For Example, persons possessing familiarity with, and sensitivity toward, securities laws and general disclosure issues should be assigned the various responsibilities (subject to clearly defined time schedule) including preparing, reviewing, editing, finalizing, printing, filing, and distributing various SEC filings, shareholder reports, and other disclosure statements; confirming due diligence; preparing, reviewing, and approving press releases; attending and approving discussions with securities analysts; responding to inquiries from the press, stock exchanges, or the public; and overall monitoring of securities law compliance. Where possible, the authorized persons should be knowledgeable both as to the relevant facts and applicable legal requirements and should be a relatively small group of persons who can provide consistency and historical knowledge to the process.

6. Control the Sources of Communication: The greater the number of people making disclosures, the greater the liability exposure. Hence, the number of people who possess nonpublic information and who are involved with issuing a disclosure should be kept to a minimum. The appropriate line operating manager should be consulted so that any announcements or interviews are in line with day-to-day reality.

Other Considerations

7. Management Stock Purchases and Sales: Recent insider trading laws and antifraud provisions of the securities laws render insiders such as directors, officers, and control persons liable to a party with whom the insider is trading corporate stock, if the insider fails to share material non-public information. Corporations should educate insiders regarding their liability and should work with them in the event an insider wishes to trade company stock.

8. Review Indemnification: A general counsel review of existing provisions for indemnification of corporate directors and officers is appropriate. Court decisions and new statutory authorizations have changed in recent years, and companies with existing indemnification provisions should ensure that the current provisions are the state of the art.

9. D&O Insurance: This is a very specialized field, and the top insurers are all too familiar with the spate of shareholder suits that occur each year. Each insurer has its own style and attitude in handling these lawsuits, and it may be worthwhile to review who insures your board to make sure your expectations in line with those of your insurer.

10. Management Resolve: The single most important factor in fighting these shareholder suits is management's tenacity and resolve to defend themselves from attack. Having a unified defense is often the difference between a motion to dismiss the case or a significant payment for "plaintiffs' fees." Ralph E. Jones III is a Senior Vice President and Managing Director of Chubb & Son Inc. He is the National Manager for Chubb's Executive Protection Department, which underwrites Directors and Officers Liability, Fiduciary Liability, and Crime and Extortion coverages for a wide array of commercial customers. The views expressed in this article are his own and may or may not reflect the views of Chubb & Son Inc.
COPYRIGHT 1992 Directors and Boards
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Chairman's Agenda: Managing Health Care Costs; includes related article
Author:Jones, Ralph E., III
Publication:Directors & Boards
Date:Jan 1, 1992
Words:2319
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