Global Policy Forum

By Gretchen Morgenson

Hats off to Alan G. Hevesi, comptroller of New York State and trustee of its Common Retirement Fund, who has proved that, yes, shareholders can hold individuals responsible for wrongdoing at companies. Institutional shareholders can no longer hide behind lame excuses for not following Mr. Hevesi's lead and demanding that the right people pay for malfeasance. Last week, 10 former directors of WorldCom agreed to cough up $18 million of their own money to settle an investor lawsuit in which the New York retirement fund was the lead plaintiff. Investors, of course, lost billions when WorldCom morphed into world bomb, leading in 2002 to the biggest bankruptcy filing in history.

The accounting fraud at WorldCom was largely the result of a scheme by its managers to dress up its results by failing to deduct proper costs from the company's revenues. WorldCom's directors were not responsible for the fraud, of course. But they were asleep in the boardroom while it was going on; so, rather than face a jury and try to explain their lapses, the 10 directors agreed to pay one-fifth of their aggregate net worth to make the matter go away. They did so only because Mr. Hevesi insisted. "I felt personally that this would be unfair and not a deterrent for future failures on the part of directors if they weren't held personally liable," he said. "The notion that companies can commit fraud and that the directors can ignore that and not meet their obligations as fiduciaries and be covered by insurance is just wrong."

Insistence like his, however, is all too unusual. Most institutional shareholders who sue corporate wrongdoers care only that their settlement money is green, not that it comes from the right people's pockets. This is insane. If a company makes a settlement payment, shareholders are essentially paying for it themselves. If the money comes from insurance, the shareholders will also pay because coverage costs will surely rise after a large settlement. And remember, these payments almost always come after stockowners' holdings have plummeted on news of questionable behavior.

Gary Lutin, an investment banker at Lutin & Company in New York who conducts shareholder forums on corporate control matters, said that the WorldCom settlement not only helped define what should be expected of company directors now - it also raised the question of what should be expected of investors. "Investors say it is too difficult, too complicated and economically unjustifiable to commit to the burdens of leadership in these areas," he said. "But what is clear is, the rules and tools have changed. Regulatory expectations of companies have changed, there are new public expectations and legal precedents. Everything has to be re-evaluated." Shareholder inertia is a good place to start.

To be sure, the forces at work against shareholders demanding accountability are formidable. First, it is tough for shareholders to succeed in lawsuits against directors who were on hand when a fraud occurred. Because the directors are typically somewhat removed from the day-to-day operations where improprieties take place, it is much harder to prove that they participated in the wrongdoing with an intent to defraud shareholders. Such intent, known as scienter, is required for success in most fraud cases. The WorldCom case was different because the company was selling securities to investors when the fraud was occurring. Because the judge found the offering statement to have been misleading, the directors faced a suit that did not require proof of their intent to defraud. That gave them impetus to settle.

Legal experts also say that courts have hot helped shareholders who were trying to hold corporate executives or directors accountable. Elliott J. Weiss, professor of law at the University of Arizona and an authority on shareholder litigation, recalled a case some 20 years ago in which he represented a shareholder against Warner Communications, the predecessor to Time Warner. At the time, Warner's major source of revenue was its Atari unit, which made computer games. When that business hit a wall, the company's stock crashed. Stockholders later learned that Steven J. Ross, the company's chief executive, who has since died, had sold some $20 million in stock right before the debacle, Mr. Weiss said. Shareholders sued and received a $16 million settlement, paid for by the company.

Mr. Ross had argued that he sold because he needed funds to cover tax bills generated by his exercise of stock options, not because of problems at Atari, Mr. Weiss recalled. "I determined that Ross had never exercised stock options that year and that even if he had, it would not have triggered taxes," Mr. Weiss said. "I filed an objection to that settlement based on the fact that Ross had acted with scienter in selling." Despite Mr. Weiss's arguments that Mr. Ross should pay the shareholders personally, the court approved the settlement, based on testimony from Mr. Ross about why he sold. "This exemplifies the judicial attitude - 'We're not going to disapprove these things because the wrongdoers aren't paying,' " Mr. Weiss said. "If you had a couple of judicial decisions rejecting settlements because there was no contribution from wrongdoers," things might change.

Another reason there have been so few settlements holding directors or officers accountable for malfeasance has to do with the huge growth in passive or indexed investing. People who invest this way, who now account for roughly one-third of all investment in the stock market, own whatever companies show up in a stock index, regardless of whether those companies are cooking their books. As a result, indexed investors owned Enron, WorldCom and most of the other scandal-plagued companies of recent years. This contributes to a dysfunctional system of capital allocation in the stock market, one in which companies are not penalized by investors who sell their shares when they spot trouble signs. In other words, there is a vastly reduced threat of ostracism from investors for companies that do wrong.

Now, however, thanks to Mr. Hevesi, shareholders have an example of how to exert pressure on companies and their boards. "Early on, Comptroller Hevesi made clear that WorldCom was the final straw and this wasn't going to be business as usual or litigation as usual," said Sean Coffey, a partner at Bernstein Litowitz Berger & Grossmann, who is one of the lawyers representing the retirement fund in the case. Will the WorldCom deal make directors see that because they are accountable, they should ask tough questions of the executives next to them in the boardroom? If not, large shareholders should keep the heat on, forcing the right people to pay whenever possible. Maybe, just maybe, the days of directors snoozing while investors are losing are over at last.

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