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Trying Times: Activists Take To The Courts

Stephen Davis and Jon Lukomnik | March 14, 2006

Meet the new policemen of U.S. corporate governance: the nation’s judges.

Like it or not, shareholder activism to exert control over board behavior is migrating as never before to courtrooms, giving magistrates and juries unusual sway over how companies are run. Canny executives can take steps to avoid getting into plaintiff lawyers’ sites. But first, take a quick scan of the landscape unfolding in 2006.

Enron’s trial, of course, has grabbed headlines. So has its civil suit. But in its shadow are other mega-cases, the latest being Nortel Networks, the Canadian telecommunications firm. Earlier this year, management settled a class action for $2.4 billion in cash, one of the biggest ever money pots for a similar lawsuit. It turns out that governance was at the root of the problem—and formed part of the resolution.


Nortel boasted an all-star board including Guylaine Saucier, who headed a blue-ribbon national commission that set best practices on, of all things, corporate governance. But directors were inattentive; they failed to detect a pattern of acute accounting irregularities. When news of the scandal broke, Nortel shares went on a dizzying crash from a 2000 high of C$124.50 to a mere C$0.67 two years later.

To no one’s surprise, big funds, led in this case by the Ontario Teachers Pension Plan Board and New Jersey's Division of Investment, filed suit. But the lead plaintiffs did not only demand financial compensation; their lawyers (Bernstein Litowitz Berger & Grossmann) pressed for sweeping governance reform.

Funds had a double motive. First, the accounting scandal might not have occurred had there been better governance, attorney Murray Gold told the Canadian media. Second, “our class members will be receiving a substantial number of shares, the value of which is going to depend—at least in part—on good governance of Nortel.”

Prompted by judge and mediator Robert Sweet, Nortel gave plaintiffs what they wanted—in money and governance. The class action settlement hands Ontario Teachers and the New Jersey fund a deciding say in reform at the company. Details are yet to be finished, but management has already pledged to benchmark its practices to standards defined by Institutional Shareholder Services. You can expect Nortel to entrench features such as an independent board chairman and majority-rule voting for directors, top governance priorities of Ontario Teachers and Canada’s other activist pension funds.

Last year $70.4 billion Royal Ahold&mdash followed a similar trajectory. Its stock price hammered in the wake of an accounting scandal, the Dutch supermarket giant—owner of Stop & Shop and other U.S. grocery chains—wound up in court facing the Public Employees Retirement Association of Colorado as lead plaintiff. Lawyers Entwistle & Cappucci joined Dutch institutional investors in demanding profound governance changes. They got them. Shell, the Anglo-Dutch oil giant, is facing a lawsuit with parallel governance overtones.

The next big courtroom clash over governance is scheduled for April 24 in Georgetown, Del., the town whose last governance drama was the face-off between investors and Disney over a $140 million payout to ousted executive Michael Ovitz. This time News Corp., another media colossus, is in the village dock. Disney judge William Chandler is again presiding. But this case isn’t about money. It’s about pure governance.

An unprecedented coalition of 12 funds from four countries charge that the firm, along with directors including controlling owner Rupert Murdoch, breached a contract-like pledge to put a poison pill to a shareowner vote. Boards across the United States are already living with the consequences of this trial.

How? For one, Chandler has awarded the plaintiffs, represented by Grant & Eisenhofer, key victories that seem to curb board powers for companies incorporated in Delaware. Before this litigation, general counsels were confident in the primacy of board authority. When News Corp.’s directors repudiated the poison pill promise the funds had extracted in exchange for supporting News Corp.’s reincorporation to Delaware from Australia, they never expected to be vulnerable to being overruled by the Delaware Chancery Court.

Chandler may not wind up overruling the News board. But one of his preliminary opinions set News lawyers’ hair on end. Instead of dismissing the case right away, he ruled that the shareowner argument had merit: that the board could not promise to award shareowners certain rights, and then by fiat withdraw them. In other words, he redefined the case. News Corp. wanted the trial to revolve around the argument that boards can do what they want under Delaware law; Chandler said that since boards derive their power from owners, they can’t make a deal with owners and then ignore it.

Of course, News Corp. could try to settle before then by agreeing to a ballot on the pill. But U.S. corporate attorneys were so concerned at Chandler’s early opinions that they urged News Corp. to seek rare action by the Delaware Supreme Court to dismiss the case. That court took just days to reject the call. So watch out: governance may get another judicial buoy marker.

Companies get dragged into court on lots of counts. How can you lower risks that governance will be the trigger at your firm?

Multiple routes are available. Fisticuffs are one. Merrill Lynch just opened a practice of aiding companies likely to be a target of governance “attack.” Law firms offer similar services. The objective seems to be to defend current practices by erecting strong takeover protections such as poison pills; ensuring management has control of the voting process; and ratcheting up public relations to keep a positive image in the public eye. While such high barriers to shareowners may discourage some battles, they would seem to guarantee that those battles that do occur are polarized, costly, and distracting. Plus, such tactics have negative connotations for many of your owners, and could depress your stock price. Finally, they seem guaranteed to extract a reputational cost on your company, CEO and board members, even if successful.

Another route is to engage with investors. Thought-leading companies such as Coca-Cola and Pfizer have well-known senior corporate officials—focused on governance, not investor relations—who regularly meet with their institutional owners. The objective is not necessarily to maintain current practices, but to win shareowner loyalty. By engaging in real dialogue, these companies have early warnings of investor concerns and reduce chances of legal attack.

Such engagement can yield corporate management insights that allow it to craft solutions that would otherwise be unattainable; witness Pfizer’s ability to institute a poison pill with minimal shareowner angst. Among the tactical options open to corporate officials: ordering a thorough profile of internal governance practices to understand where they diverge from current investor opinion; entering into preemptive governance dialogue with influential funds; appointing a senior official as a corporate governance officer with responsibility not only for internal governance but also for dialogue with investors over appropriate issues, and, perhaps most importantly, making changes to governance structures to position the firm among the best-in-class.

There is no guarantee any strategy will keep judges at bay. But now that governance is (quite literally) on trial, boards can no longer treat it as discretionary. It is a must-do.


The authors have served as consultants to various law firms, including Grant & Eisenhofer and Entwistle & Cappucci.

This column solely reflects the views of its authors, and should not be regarded as legal advice. It is for general information and discussion only, and is not a full analysis of the matters presented.