Possible Limitations on Securing Corporate Governance Reforms Through Class Action Settlements
By John Landry

In settling federal securities class actions, court-appointed “lead plaintiffs” increasingly are seeking to include corporate governance reforms as part of the overall settlement consideration. As this trend continues, and as lead plaintiffs—more often than not, institutional investors—seek to play a more direct, active role in effecting governance reforms, the question arises: At what point, if any, do these efforts exceed the lead plaintiff’s authority?

Knowing the limitations on the lead plaintiff’s ability to demand governance changes may help preclude the inclusion of terms that could later derail a settlement in which the parties will have invested substantial time and effort. Although courts have not yet directly examined the issue, some basic rules provide guidance. In particular, rules requiring that all class members share in the settlement consideration on a pro rata basis may limit the lead plaintiff’s authority to bargain for reform measures that effectively grant it a special right or benefit that other class members do not enjoy.

The “Most Adequate Plaintiff” Requirement

Ten years ago, Congress sought to end the common practice of plaintiffs’ bar attorneys initiating and managing securities class actions through the use of “figurehead” clients. The solution was the “lead plaintiff” requirement that became part of the 1995 Private Securities Litigation Reform Act (“PSLRA”): “[T]he court shall appoint the most adequate plaintiff as lead plaintiff for the consolidated actions.”¹ As a result of this change, the goal now “is to locate a person or entity whose sophistication and interest in the litigation are sufficient to permit that person or entity to function as an active agent for the class.”² The PSLRA establishes a presumption that the “most adequate plaintiff” is the one with the largest financial stake in the recovery sought by the class.³

The Institutional Investor as Plaintiff

As a result of the PSLRA’s lead plaintiff requirement, federal securities class actions have fallen increasingly under the control and management of institutional investor plaintiffs. In fact, this was the expected and desired result. An institutional investor frequently has the largest financial stake in the case, and is more likely than an individual investor to take an active interest in controlling the litigation, thus furthering Congress’ intent that actual parties, not counsel, make the decisions.⁴

Institutional investors, however, also tend to approach settlement decisions with their own unique perspective. Unlike individual plaintiffs—who have usually sold their shares in the issuer prior to filing suit and who desire only to maximize their monetary recovery—institutional investors generally retain an investment relationship with the issuer.⁵ As a result, institutional investors are likely to recognize that a large monetary recovery will translate into a corresponding decrease in the value of their current holdings in the defendant issuer.⁶

Despite their conflict of interest, courts generally do not disqualify institutional investors who are current shareholders of the issuer from acting on behalf of a class that includes former shareholders.⁷ As the Cendant court explained, when Congress expressed its preference for institutional investors as lead plaintiffs, it understood that an “institutional investor with enormous stakes in a company is highly unlikely to divest all of its holdings in that company, even after” it becomes a class member in a securities class action.⁸ It follows that Congress also accepted the inherent conflict of interest presented whenever, as is typically the case, an institutional investor retains an interest in the defendant issuer.⁹

Corporate Reforms as Settlement Consideration

Given their continued status as investors in the issuer, institutional investors are naturally more inclined to pursue as part of a settlement—in addition to a traditional cash pay-out—long-term, remedial measures to prevent or deter possible future violations. In the last few years, in particular, the number of securities class action settlements that include corporate governance reforms have increased. Examples of reforms that lead plaintiffs recently have obtained through settlement include:

• An increased number of independent directors;
• De-classification of the board;
• Term limits for directors;
• Increased participation by shareholders in director nominations;
• The rotation of a firm’s outside auditor; and
• Changes in director and officer compensation.¹⁰

Most recently, in a further step away from the cash-only class action settlement, lead institutional investor plaintiffs have negotiated the structure of some corporate reforms in a manner that allows them to play an active role in effecting and implementing the reform. The recent settlement of a securities class action against Dynegy illustrates this development. In that case, the lead plaintiff, the Regents of the University of California, negotiated a settlement that requires Dynegy to pay $468 million in cash and stock to the class, but also allows the UC Regents to nominate a slate of five directors, two of whom are then to be elected to Dynegy’s board of directors.¹¹

What accounts for this new effort by lead plaintiffs to influence the governance reform process? One possibility is the Sarbanes-Oxley Act that, with its emphasis on corporate governance reforms as a panacea for corporate fraud, has encouraged lead plaintiffs to demand similar or complementary reforms. In addition, the appointed fiduciaries of public pension funds, such as the New York State Common Retirement Fund and other similar quasi-governmental institutions, may in fact view the lead plaintiff role as an opportunity to regulate indirectly.¹² Whatever the reasons, lead plaintiffs are likely to continue to seek greater influence by injecting themselves into the governance reform process.

Potential Limits on the Power of Lead Plaintiffs to Negotiate Reforms

Lead plaintiffs’ new efforts to play an active role in corporate governance reforms raise the question of how far a lead plaintiff can go. After all, a lead plaintiff’s authority to conduct and settle litigation on behalf of a class is not without limits.¹³ Some basic rules may help provide guidance. First, a settlement that purports to secure non-monetary reforms for the benefit of the class but actually creates no real value for the class is likely to be rejected. For example, in Polar International Brokerage Corp. v. Reeve, the lead plaintiff negotiated a settlement that provided the class an additional opinion that the terms of the tender offer at issue in the suit were fair and reasonable, but no monetary payment.¹⁴ The court rejected this proposed settlement, explaining that it “puts no additional money in class members’ pockets; what it offers is reassurance that the price they received is ‘not unfair.’ This benefit is of little value.”¹⁵

Second, although a lead plaintiff’s status as an institutional investor does not present a disabling conflict, the actual corporate governance reforms it secures from the defendant may raise issues regarding whether the lead plaintiff has, in fact, acted in the best interest of the class as a whole. Thus, a reform that bestows a benefit on only the lead plaintiff or other institutional investors at the expense of more recovery for the class overall is subject to potential challenge.¹⁶

For example, in Cendant, the court was greatly troubled by corporate governance reforms that provided a benefit only to those class members like the lead plaintiff, the CalPERS Group, that retained an interest in the issuer. The court ultimately approved the settlement (which included a $3.2 billion cash payment) in part, because of atypical facts: CalPERS submitted affidavits, including one from Cendant’s general counsel, stating that during negotiations Cendant did not receive any economic concessions for adopting the corporate governance changes that CalPERS demanded.¹⁷ Note, however, that courts approving other recent corporate reform settlements did not find it necessary to address the concerns raised in Cendant, despite empirical analysis suggesting that trade-offs between cash payments and reforms did occur.¹⁸ The large cash components of these settlements, plus the likely view that litigation-driven governance changes largely comport with the securities laws’ overall deterrence goals, may account for the lack of judicial scrutiny of such trade-offs.

Third, it is well recognized that a lead plaintiff violates its fiduciary duty of loyalty if it obtains for itself a benefit not shared by the rest of the class.¹⁹ Similarly, the text of the PSLRA prohibits the lead plaintiff from accepting any payment beyond its pro rata share of any recovery.²⁰ Thus, potentially more controversial are settlements, such as the recent Dynegy settlement, that reserve for the lead plaintiff—and the lead plaintiff alone—a special role in the governance reform process.

If the Dynegy measure effectively results in the installation of new independent directors, it is a reform not uncommon in class action settlements, and may be viewed as consistent with the securities laws’ remedial goals. A greater degree of director independence also arguably benefits other class members to the extent they also maintain an investment relationship with Dynegy. On the other hand, the reform mechanism in Dynegy bestows on the UC Regents alone the valuable right (in a real economic sense) to nominate, and in effect elect, two directors; this same benefit is not extended to any other class member. Although the UC Regents may nominate two directors whom they believe will serve in a manner that benefits others in the class, an objector could argue that the UC Regents have reserved for themselves a settlement premium contrary to their responsibilities to the class as a whole and in violation of the PSLRA.²¹

This is not to suggest that those arguments would prevail. In fact, no class member objected to the Dynegy settlement on those grounds. Nevertheless, it is not unreasonable to anticipate that in a future case a shareholder who is also a member of the class may appear to object to the settlement or to seek similar rights for other class members. In any event, the Dynegy settlement well illustrates the potential issues that may arise when lead plaintiffs reserve special rights for themselves.²²

Conclusion

As institutional investors continue to serve as lead plaintiffs and seek corporate governance reforms, courts are more likely to confront the question of whether such reforms constitute unfair settlement premiums. Congress has made clear that it prefers institutional investors over other securities plaintiffs to initiate, manage, and settle class action securities litigation. However, the institutional investor’s ability to play an active role in effecting corporate reforms in the context of settling lawsuits is likely subject to limits that parties must recognize.

Notes

1. 15 U.S.C.A. § 78u-4(a)(3)(B)(ii).

2. In re Cendant Corp. Sec. Litig., 404 F.3d 173, 192 (3d Cir. 2005) (internal quotation omitted).

3. 15 U.S.C.A. § 78u-4(a)(3)(B)(iii). Notwithstanding these reforms, courts have questioned whether the PSLRA goes far enough. For example, in In re Molson Coors Brewing Co. Sec. Litig., Fed. Sec. L. Rep. (CCH) ¶ 93,593, 2005 U.S. Dist. LEXIS 30569 (D. Del. 2005), the court lamented the “‘pick me’ urgency” characterizing motions for appointment as lead counsel. Id. at *7 n.4. Although the competing groups of plaintiffs in that case included institutional investors, the court observed that “it appears that the lawyers are still very much in the driver’s seat.” Id. Accordingly, the court “question[ed] whether the right incentives are yet in place.” Id.

4. See In re Cendant Corp. Litig., 264 F.3d 201, 243-44 (3rd Cir. 2001).

5. Id. at 244.

6. Id. at n.25.

7. See, e.g., id. at 243-44.

8. Id. at 244.

9. Id. Institutional investors may not take this conflict of interest into consideration in their decision-making process. Evidence suggests that, despite any conflicts, “the presence of an institutional investor as a lead plaintiff is associated with a statistically significant increase in settlement size.” See Laura E. Simmons & Ellen M. Ryan, “Post-Reform Act Securities Settlements: 2005 Review and Analysis,” 9 (Cornerstone Research ed. 2006).

10. See Elaine Buckberg, Ph.D. et al., “Recent Trends in Share Holder Class Action Litigation: Bear Market Cases Bring Big Settlements,” 10-11 (NERA Economic Consulting ed. 2005); PricewaterhouseCoopers LLP, “2004 Securities Litigation Study,” 12 (2005).

11. See Dynegy Form 8-K, dated April 15, 2005, Exhibit 99.2.

12. See Karen Donovan, “Legal Reform Turns a Steward into an Activist,” N.Y. Times, April 16, 2005, at C1 (discussing the significant role of NewYork State Comptroller Alan G. Hevesi in settling securities class actions).

13. The PSLRA does not delineate the specific powers and responsibilities of the lead plaintiff. Courts generally recognize that lead plaintiffs have all the power to control the litigation that a plaintiff in an individual action would have, including the authority to decide whether to settle and on what terms. See In re Cendant Corp. Sec. Litig., supra note 2, at 198.

14. 187 F.R.D. 108, 117-18 (S.D.N.Y. 1999).

15. Id. at 117.

16. In re Cendant Corp. Litig., supra note 4, at 246.

17. Id. at 246-47.

18. See Buckberg, supra note 10, at 11.

19. See In re Cendant Corp. Sec. Litig., supra note 2, at 198; Wied v. Valhi, Inc., 466 A.2d 9, 15 (Del. 1983).

20. 15 U.S.C.A. § 78u-4(a)(4).

21. In addition, Dynegy has at the same time arguably extended to the UC Regents certain special franchise rights not granted to any other present holder of Dynegy shares, in possible contravention of state law rules governing the equal treatment of holders of the same classes of shares.

22. To the extent securities class actions are accompanied by companion shareholder derivative suits, the settlement of the derivative suit—a non-class action—may afford a vehicle to effect governance reforms while avoiding these issues.

About the Author

Mr. Landry (john.landry@hellerehrman.com) is a shareholder in the Los Angeles office of Heller Ehrman LLP.