If prosecution benefits a company's governance, should it pay its accuser's legal fees? One Judge says 'yes'
Most companies view shareholder lawsuits, and any legal action against them, as a bad thing. And they have a point. But in a recent suit it was suggested that it is actually possible for a company to benefit from a suit if it leads to significant structural changes in the way that it conducts business. In this case, the ‘benefits’ were governance changes forcibly implemented as part of the settlement.
The true benefits of corporate governance have been under debate for some time. Proponents claim that improved governance practices lead to more effectively run companies, better corporate strategy and an overall improvement in profitability and share price. Detractors point to extremely high costs of implementation, the distraction of management and board attention, spurious shareholder actions and arguable real benefits.
Now, a judge has thrown her personal opinion into the ring on the side of the governance supporters. In a move that many observers feel is unusual judge Katherine Hayden stated that Schering-Plough, its CEO Fred Hassan and its executive management benefited as a direct result of a shareholder derivative lawsuit. The case is In re Schering-Plough Shareholders Derivative Litigation, (01-Civ.-1412).
What makes the ruling unusual is that, although the judge awarded no damages as a result of the settlement, she did enforce the payment of plaintiff’s counsel fees of $9.5 million and approximately $300,000 in expenses. The fee award was based on a lodestar of $6.95 million, enhanced by a multiplier of 1.37. In making the decision, Hayden remarked ‘Although attorneys’ fees have historically been awarded from financial recoveries, an award of counsel fees is justified where a corporation receives a substantial benefit from a derivative suit.’
The benefits resulting from the settlement involved structural board and management oversight changes. Specifically, the company agreed to replace staggered terms for the election of the board of directors with annual elections for every seat; repeal board meeting and committee fees used to compensate board members and replace them with an annual retainer; enhance communication between the board and management; and centralize global compliance and audit functions.
Certainly the first two governance reforms mentioned above are broadly considered best practice. A majority of S&P 500 companies now hold annual elections for all board positions. Annual retainers for directors are becoming more common but payment for committee service remains a more opaque topic. Many companies no longer pay fees for merely attending committee meetings although payments for serving as chairperson of major board committees are increasing. This is especially the case for the chairs of audit and compensation committees.
Who should judge company best practice?
It may be that these governance changes benefited the company. The question, however, and the thing that has many general counsel and in-house legal teams concerned is: Is it the role of a judge to impose governance reforms and then pass judgment on the benefit of such reforms?
One assistant general counsel and corporate secretary from a New York area S&P 100 company who requested anonymity remarks, ‘Many companies have come to these outcomes on our own or in constructive consultation with shareholders. My concern is that this type of settlement may encourage small activist shareholder groups with a specific agenda to initiate legal proceedings not because any real damage has been done to them but because they see it as an opportunity to enforce structural changes.’
In her opinion, Hayden went on to write, ‘the adoption of corporate governance and compliance mechanisms required by the settlement can prevent breakdowns in oversight that would otherwise subject the company to the risk of regulatory action, or uncover and remedy a problem at the early stages before it becomes the subject of a government investigation.’
Susan Ellen Wolf, corporate secretary, vice president-governance and associate general counsel at Schering comments, ‘Regarding the derivative settlement, we are proud of the changes highlighted in the settlement which were made in Schering-Plough’s compliance and governance areas under the leadership of CEO Fred Hassan and with strong support from our board. We were pleased to see the lawsuit, which relates to issues from the past, put to rest.’
The litigation was prompted by an announcement by Schering-Plough in early 2001 that the Food and Drug Administration (FDA) had delayed approval of Clarinex because of concerns over continued deficiencies at manufacturing facilities in New Jersey and Puerto Rico. This was despite the FDA sending the company several warning letters highlighting its concerns, prior to the announcement.
Pursuant to a May 2002 consent decree, the company agreed to pay the FDA $500 million and made a commitment to tighten quality controls. This was, however, too late to stave off the derivative litigation, which had already been filed.
The suit, which was filed on behalf of a Pennsylvania union’s pension fund, alleged that, by repeatedly ignoring warnings from the FDA about quality controls and manufacturing deficiencies, the directors had failed to meet their fiduciary duty to shareholders and the company.
Furthermore, because Clarinex was predicted to be a major asset to the company and was a replacement to the top selling allergy drug Claritin (which was about to lose patent protection) the plaintiffs allege that the delay in FDA approval was directly responsible for a drop in Schering’s stock price and caused damage to the company’s reputation. ‘By continually ignoring repeated and clear warnings regarding manufacturing and quality control deficiencies, the management and board put at risk the company’s ability to manufacture and market its products and its standing with regulatory authorities,’ the plaintiff’s lawyers claimed in the suit.
As part of the action, the plaintiffs asked for the creation of a new corporate department responsible for monitoring ‘good manufacturing practices’ that comply with FDA requirements and reporting the findings to the board. In addition to this department they also sought the formation of a board-level compliance committee to be made up of a majority of independent board members. This committee was to have the authority to engage outside consultants and subject matter experts.
The parties commenced negotiations during 2003 and employed the services of retired US magistrate judge Edward Infante to act as mediator. The engagement led to a stipulation of settlement in October 2007.
‘Although the settlement did not recover the money losses, the fundamental aim of the litigation was to correct the board’s failure of oversight, and the resulting damage to Schering, by implementing specific changes to Schering’s corporate governance mechanisms,’ wrote Hayden.
She continued, ‘The monetary losses and the regulatory troubles with the FDA are the fruit of the same tree, stemming directly from a breakdown in Schering’s managerial structure. Thus, the most important motivation for maintaining this action was to prevent future losses of this ilk by changing how the corporation’s directors oversee the running of the corporation.’
Hayden did recognize the significant steps taken by Schering-Plough and noted that dramatic increases in spending by the company on compliance and governance systems which were prompted by the litigation ‘demonstrates the complexity and breadth of the changes to Schering’s corporate governance structure attributable to the efforts of plaintiffs’ counsel.’
Despite their success in achieving long-term structural changes to the oversight and governance systems at Schering the plaintiff group did not achieve all their goals. They had also sought a refund of directors’ salaries and disgorgement of the proceeds of alleged insider trading. In addition, they sought to hold directors liable for any and all losses sustained as a result of governance deficiencies including losses from other lawsuits and regulatory actions that may arise as a result of the highlighted failures.
Paying for unknowns
When justifying her decision to award payment of lawyers’ fees despite no financial penalty being enforced, judge Hayden explained that the governance changes implemented as part of the settlement were likely to result in a long-term benefit for the company. She highlighted that eliminating the staggered board structure would reduce the risks associated with director entrenchment. She did not, however, clarify what these risks are and there are a number of companies that retained a staggered board structure and have not experienced any significant harm as a result. This is a hot button issue for many activist investor groups and proxy advisory firms, mostly on the grounds that it is undemocratic.
She continued that ending fees for committee work would promote transparency. It is also unclear as to exactly how this will be done. All director payments including annual retainers, committee and meeting fees and other expenses are disclosed in annual regulatory filings.
One conclusion that it is difficult to argue with is that centralizing global compliance and audit functions will facilitate more effective direct reporting of compliance issues to the board, Hayden pointed out. Although, according to the plaintiff’s argument, it was not a lack of reporting that resulted in the problems at Schering but a lack of action on the part of the board and management in responding to FDA warnings.
The $9.5 million fee and $300,000 in expenses will be split among the plaintiffs’ lawyers, Morris & Morris in Wilmington; Squitieri & Fearon and Abraham Fruchter & Twersky, both in New York; and the law offices of Bernard Gross in Philadelphia. All plaintiffs’ lawyers declined to comment on the settlement or its possible impact on future cases.
Speeding up the inevitable
Professor Gregory Mark, associate dean for institutional affairs, professor of law and justice, Nathan Jacobs Scholar at Rutgers Law School-Newark, was quoted in the New Jersey Law Journal as saying the settlement ‘looks like an expensive way to get things that probably ought to have happened anyway.’ He continues that, ‘Of all the changes agreed to by Schering-Plough, the end of the staggered board is likely to have the biggest effect. For better or worse, it will make the corporation’s management more sensitive to immediate shareholder concerns.’
Although many companies have implemented significant structural changes over the past several years and board involvement in oversight of management is far more active than it was in previous decades, shareholders continue to push for governance changes.
It is becoming clear that perceived failures in governance structure are a risk not only to company operations but also to board members and management of those companies. It is also clear that in this time of increased disclosure scrutiny that failure to take action when problems are brought to the attention of the board can result in serious personal and professional risk, even though in this case disgorgement was not enforced.
