While shareholder lawsuits show no sign of abating, the recent settlement of a class-action suit against Cendant Corp. may represent a sea change in securities litigation. Yet that change has less to do with the unprecedented size of the settlement than with the fact that institutional investors replaced plaintiffs’ attorneys as the driving force in the case. And despite the huge damages involved, it’s welcome news to corporate risk managers that institutions called the tune. Reason: Shareholders, unlike plaintiffs’ attorneys, have less interest in bringing a company to its knees.
That’s not to say investors aren’t interested in big damage awards. On December 7, New York-based Cendant, a marketing and franchising firm, agreed to pay 440,000 shareholders $2.85 billion to settle a suit that stemmed from fraud committed by executives at CUC International, which merged with HFS International to form Cendant in 1997.
The payout is more than 10 times the size of the next-largest shareholder recovery — a $220 million settlement at Waste Management Inc. last year. And according to lawyers for the California Public Employees’ Retirement System (Calpers), one of three institutional investors serving as lead plaintiff in the suit, the payout (along with the $335 million recovered from CUC auditor Ernst & Young) will cover an unusually large 37 percent of the losses suffered by shareholders after Cendant announced it had discovered “accounting irregularities” at CUC. As it turned out, those represented some $500 million in fake revenue (see “Hear No Fraud, See No Fraud, Speak No Fraud,” October 1998).
But as big as those damages are, they stop well short of driving the company out of business. Indeed, the institutional investors and their counsel hired investment bank Lazard Freres to analyze Cendant’s cash flow, financial position, and insurance coverage to determine exactly what the company could afford to pay. “We needed to balance the long- term viability of the company with its short-term ability to pay,” says Max W. Berger, counsel in the class action for Calpers, as well as for the New York Common Retirement Fund and the New York City Pension Funds. That’s more consideration than the class-action bar would likely show.
A Broad Agenda
Unlike plaintiffs’ attorneys, investors like Calpers, which still owns a large stake in Cendant, have an interest in seeing the company recover. As part of the settlement in this case, Cendant management agreed to implement the broadest agenda of corporate-governance changes that any company has ever agreed to as part of a shareholder securities suit (see “Playing by Investors’ Rules, at the end of this article). The changes will increase the independence of the Cendant board and its key committees, and force the company to seek shareholder approval to reprice the stock options of corporate managers.
“We argued that the more confidence [the settlement] instills in the investment community, the more it would enhance shareholder value,” says Berger. “The company agreed.”
Granted, with what Cendant CEO Henry Silverman called “a tobacco-like liability” hanging over its head, management had little choice. “It’s called good governance at gunpoint,” says Patrick S. McGurn of Institutional Shareholder Services. With institutional investors, rather than plaintiffs’ attorneys, holding the gun, corporate-governance issues may become a more common part of shareholder litigation settlements. Up to this point, however, few institutions have thought it worth the time and effort to get involved with litigation. The successful outcome of the Cendant suit may change that. And to the extent that governance changes substitute for even larger damages, the Cendant settlement may have a silver lining.