Governance at Gunpoint

Institutional investors were attempting to settle an accounting-fraud lawsuit against Cendant Corp. in the late 1990s when they made an unusual demand: Overhaul your corporate governance, they told the company.

It was a radical notion at the time -- leaving some other shareholders of the New York real-estate and travel-services company worried that asking for intangibles like greater board independence and restrictions on employee stock options risked leaving money on the table.

In the end, Cendant agreed to the governance changes and paid out $2.8 billion -- one of the largest amounts ever in settling such a suit.

'One More Weapon'

Fast-forward to today, and the idea of pushing governance reforms as a way to settle shareholder lawsuits has become mainstream. It's "just one more weapon in the war being waged, largely by public institutions, to improve corporate-governance practices," says Glen DeValerio, a partner at Berman DeValerio Pease Tabacco Burt & Pucillo.

His Boston-based firm helped extract cash payments and a host of reforms at Enterasys Networks Inc. in 2003 as the result of a class action brought against the company the previous year. In the lawsuit, the lead plaintiffs, the Los Angeles County Employees Retirement Association, or Lacera, alleged that the Andover, Mass., computer-hardware company engaged in accounting manipulations to inflate its stock price from mid-2000 to early 2002. Enterasys agreed to pay $50 million in cash and stock to the plaintiffs and to begin a process leading to annual elections of board members, among other reforms. In settling the suit, the company denied the allegations.

Companies settling lawsuits by, in part, agreeing to governance changes in recent years include Dallas utility TXU Corp., Houston natural-gas and oil-field-equipment maker Hanover Compressor Co. and Witchita-based Lone Star Steakhouse & Saloon Inc.

"On the whole, I think these 'governance by gunpoint' settlements are a good thing because they can help to motivate other companies that need a kick in the pants," says Broc Romanek, a former Securities and Exchange Commission lawyer and editor of TheCorporateCounsel.Net, a securities-law Web site in Arlington, Va. "Some of these companies might have undertaken reform on their own once the board got wind of the reasons that led to the lawsuit," Mr. Romanek says. "But often these boards are subject to the settlement provisions themselves and need help getting to better governance practices."

Improving governance isn't necessarily the first thing on shareholders' minds when they initiate a lawsuit. During negotiations to settle the Enterasys suit, plaintiffs' chief counsel David Muir says, "we didn't talk at all about any corporate-governance issues until we completed the negotiations of damages." Lacera pushed for governance changes only after a proposal to issue new shares was floated, Mr. Muir says. "We felt that by enhancing corporate governance we could add value [to the new shares]," he says. "It seemed to be particularly appropriate."

Where a breakdown in corporate oversight is considered the root cause of the problems, however, plaintiffs have been eager to go beyond simply forcing a company to cut a check for past misconduct.

Breaking the Cycle

"What my clients tend to want to do is try to avoid having it all repeat itself again, and hopefully improve the lot of everyone involved," says Darren J. Robbins, a partner at the law firm of Lerach Coughlin Stoia Geller Rudman & Robbins, who helped clients negotiate governance changes at Hanover Compressor and in other cases.

But some companies still aren't keen to allow shareholder litigants to dictate their governance practices. In the case of Enterasys, the settlement seemed to be progressing well and was "largely absent any rancor," until Lacera decided it wanted to see changes such as directors running for election each year rather than in staggered terms. "They hit the ceiling," recalls Mr. DeValerio, the co-lead counsel. "It was a long, bitter fight," he says.

Enterasys officials didn't return calls for comment.

Some experts who assist companies hit by shareholder lawsuits say that negotiating governance reforms can work in a company's favor. "If I were the corporation, I would think it's quite favorable, making reforms that are likely to increase stock price and ratings for corporate governance and transparency," says Elaine Buckberg, a vice president at NERA Economic Consulting, a New York-based firm that provides economic analysis to defendants in securities-fraud cases.

There can be immediate advantages, too, such as helping to avoid a protracted fight inside a courtroom, and, more important, possibly reducing payouts. Data are scarce thus far, because governance changes generally aren't mentioned in the notices that go out to investors when a shareholder lawsuit is settled. But in a handful of cases tracked by NERA since Sarbanes-Oxley was enacted in 2002, evidence suggests that the plaintiffs in a majority of those cases agreed to reduced cash payouts in return for governance reforms. Of the eight settlement agreements tracked that included cash and governance reforms, five included financial payments that were at least 40% lower than NERA's model had predicted, and only two turned out to be higher.

Cash First?

Plaintiffs and their attorneys are highly sensitized to accusations of leaving money on the table. "In all cases of securities fraud, you should be getting financial recovery first," says Stuart Grant, a partner at the Wilmington, Del., law firm of Grant & Eisenhofer, which has worked governance changes into several settlements on behalf of pension-fund clients, including in the Lone Star case. "If there is an opportunity to also get corporate-governance reforms, all the better," Mr. Grant says. "But you shouldn't be trading dollars away for corporate-governance reform."

One investor, a Long Beach, Calif., woman, felt this was exactly what happened in the case against Cendant, which led her to file a formal objection to that company's 1999 accounting-fraud settlement. The filing, in the Third U.S. Circuit Court of Appeals in Philadelphia, accused the institutional investors acting as lead plaintiffs in the suit of bargaining away a bigger payout in return for governance changes. The court ruled against the objection.

Attorneys for the plaintiffs in the Cendant case denied giving away anything. Co-lead counsel Jeffrey W. Golan, a partner at Barrack, Rodos & Bacine in Philadelphia, says: "The negotiations on the amount of the Cendant payment were undertaken and completed before any discussion of corporate governance. We believed strongly that we obtained the maximum payment that Cendant would make to settle the case."

Cendant didn't return calls for comment.

Balancing Act

Though denied, the legal challenge to the Cendant settlement serves to underscore the point that it can be difficult to balance the needs of all the plaintiffs in shareholder suits. Large public pension funds have been the biggest force for change in boardroom practices, but shareholder lawsuits often involve a wide swath of investors, including mutual funds and individual investors -- some of whom may no longer hold the shares of the company being sued. These investors may care little about how the company is run in the future, and instead may want only cash.

Settlements that involve only governance changes, meanwhile, can work to the advantage of both shareholders and the company. Take Ashland Inc., the Covington, Ky., transportation, chemicals and petroleum company. In a shareholder suit filed against Ashland in 2002, the Central Laborers Pension Fund, of Jackson, Ill., alleged that directors and officers of the company had failed to adequately oversee operations and protect shareholder value.

In the settlement that followed earlier this year, Ashland admitted to no wrongdoing and no damages were paid. But the company proved amenable to such governance reforms as encouraging more shareholder nominations for board seats.

"It was a good resolution and certainly helped us to avoid the distraction and expense of litigation," says Ashland general counsel David L. Hausrath.

Some concessions were hardly changes at all, the company says. Agreeing to have independent directors represent two-thirds of the board, for example, was easy, Mr. Hausrath says, since the board had already maintained such a percentage for nearly 20 years. Appointing a lead independent director was easy, too, Mr. Hausrath says, because the company already had what it termed a "presiding director" who served many of the same functions, including running executive sessions without management board members present.

Ed Smith, chairman of the plaintiff pension fund, says that his organization left no money on the table as a result of pressing for governance changes. In the end, he says, the fund saw the pursuit of governance reforms as more worthwhile for the company and its shareholders than seeking financial damages.

"What we're trying to do from a pension fund's point of view is look at this over the long term," he says. "We measure value in lifetimes of our participants. The idea is to add more money over the long haul" by increasing shareholder value.

Recent trading in Ashland stock suggests that goal was achieved. Since falling roughly 50% to around $25 a share in 2002, the year the suit was filed, Ashland's stock has rebounded to around $55.

Whether or not CEOs welcome the new shareholder activism, it's probably here to stay, lawyers say. Given the success many plaintiffs have had in forcing governance reforms -- and the likelihood that corporate wrongdoing will continue -- activist public pension funds will probably continue to wield the governance club as an inducement to settle, says Mr. Robbins, the Lerach partner.

Write to Phyllis Plitch at phyllis.plitch@dowjones.com