In Your Best Defence


1 March 2007 Ric Marshall


The cost of securities class actions is growing and your company could be hit next. Ric Marshall, chief analyst and co-founder of The Corporate Library, explains how to avoid the full impact of successful suits.


The filing of securities class action (SCA) litigation can initiate a CEO's ultimate nightmare, including negative scrutiny by the press and government regulators, depressed or uncertain share prices and a significant loss of time and focus.

While D&O coverage usually covers the main expenses, no such coverage exists to replace the more subtle costs involved. For a few unfortunate companies each year, such litigation signals the beginning of the end, as they cannot regain lost ground.

It is a problem that is not going away. According to the 2006 year-end review by Cornerstone Research, while the frequency of SCA filings against US corporations is at an all-time low, average settlement sizes continue to rise sharply, even after adjusting for Enron, Worldcom and other 'mega-settlements'.

Institutional investor involvement in SCAs is also growing, with large institutional investors taking the role of lead plaintiff, driving settlements even higher. Derivative claims, where shareholders demand that their company takes legal action against past executives or board members, are of increasing concern as well.

Although they are unlikely to result in large settlements on their own, as they are often focused on forcing governance changes, where they accompany a securities class action claim, they can result in a higher settlement. Even worse, settlement times are getting longer, with many cases now taking five years to settle, a major increase from the three-year periods of just five years ago.

The best defence is to avoid such suits in the first place. For companies in certain high-risk industries, including most high-tech and healthcare firms, those attracting high daily trading volumes and those with a strong institutional investor presence, exposure to SCAs is unavoidable.

But the most important contributor is governance risk. A majority of SCA claims reflect basic governance weaknesses in the defendant company and could have been avoided if the company's management and board had taken a more proactive position on this important yet poorly understood aspect of overall corporate risk.

Governance risk involves a wide spectrum of factors, ranging from the negative impact of weak, ineffective boards to outright criminal fraud. But most governance risk factors can be minimised once they have been identified.

There are six simple things that you can do to minimise the risk of successful SCA litigation and help you keep settlements as low as possible.

1. KEEP YOUR BOARD INDEPENDENT

Claims of unchecked management self-interest, together with claims that the board was not sufficiently independent of the CEO to provide such checks and balances, are the most common arguments made in SCA filings. While Sarbanes-Oxley and the exchange listing rules have highlighted the importance of board independence, many CEOs still assume that the board's main role is to support the CEO.

"The news that is not stated can turn out to be the most damaging."

The most effective CEOs, however, understand the value of a genuinely independent board, particularly when the CEO's actions fall under the light of external scrutiny. Fortunately, this view is on the rise.

Fully independent directors can better support a CEO under fire than those that may be inherently conflicted by virtue of their close personal alignment.

2. USE INDEPENDENT EXPERTS

Closely related to the importance of a fully independent board is the need to effectively use independent outside experts. This ensures independence and minimises the case for scienter – the legal concept of advance knowledge, based on the notion that defendants must know, or be deemed to know, in advance, the consequences of their actions or non-actions – which is often the single most important element needed by the plaintiff's bar in mounting successful SCAs.

For example, boards at companies in high-risk industries might want to minimise the likelihood of demonstrable scienter by installing a strategic decision-making audit procedure conducted by independent experts to review management decisions that might give rise to lawsuits and liability.

To be effective, these specialised auditors – quite different from the company's independent accounting auditor – must report directly to the appropriate board committees with recommendations for remediation as required.

Sarbanes-Oxley comments explicitly on this with regard to the audit committee, but it can be easily and effectively extended to the other standing board committees as well.

3. LINK CEO PAY TO PERFORMANCE

CEO pay that is poorly linked to performance remains the single most statistically significant governance indicator of SCA risk. This is especially true of annual incentive awards, where the potential for accounting manipulations intended to enhance such awards is highest.

While a precipitous drop in share price is most often the cited reason for the filing of an SCA, excessive or poorly aligned CEO pay often drives a claim's success. Whether or not you believe that CEO compensation practices are broken, they are clearly a key driver of governance risk, particularly in the SCA context.

"Overly optimistic reporting by management is cited in a very high percentage of security cases."

4. AVOID ANTI-TAKEOVER DEVICES

While the most commonly applied anti-takeover devices, such as classified board elections and poison pills, are not directly correlated with the filing of SCAs, their existence is increasingly being cited as evidence of intentional CEO and/or board entrenchment, and can have a negative impact on settlement amounts.

As they serve little purpose, CEOs and boards are increasingly rejecting them, lowering their overall governance risk.

5. ADOPT INDUSTRY BENCHMARKING

Take a lesson from the plaintiff's bar: if you are not benchmarking your corporate governance practices against your industry peers, you should certainly begin to do so. This is another item that might not help prevent the filing of an SCA against your firm, but will almost certainly help limit its impact.

The plaintiff's bar is increasingly focused on highlighting perceived governance weaknesses in support of its primary claims. By regularly benchmarking yourself against your industry peers and competitors, and adjusting your practices accordingly, you can easily all but eliminate this potential threat.

6. MAKE SURE DISCLOSURE IS HONEST

We are all inclined to put the best possible spin on a bad situation, but overly optimistic reporting by management is cited in a very high percentage of securities cases, and greatly heightens a company's exposure to SCAs. Anything short of the highest possible disclosure standards can cost millions. This is especially true if your company is experiencing a high level of market interest, as reflected by high trading volumes.

You can't slow down the trading, nor would you want to, but you can be certain that the interest is based on factual reality, and in some cases it is the news that is not stated that turns out to be the most damaging.

Although it is impossible to avoid SCAs, it is certainly possible to limit their effect. By implementing the six practices outlined above, companies can minimise governance risk factors, making successful suits less likely.