Be Careful What You Wish For
On the Road
Silicon Valley companies thought an act of Congress would solve their problems with Bill Lerach and his shareholder lawsuits. But reforms can work in quirky ways.
Seven years ago Silicon Valley's power elite set out on a high-stakes mission to wipe out what they regarded as a scourge in the high-tech industry. Their target: Bill Lerach, who had hammered hundreds of high-tech companies with lawsuits accusing management of swindling shareholders. Owing in part to volatile stock prices, newly public technology companies in the Valley then stood about a 70% chance of being hit with such suits. And Lerach's law firm, Milberg Weiss Bershad Hynes & Lerach, had crafted more than half of all the complaints.
Fearing Lerach's wrath, those who plotted his downfall -- senior managers at companies such as Hewlett-Packard and Silicon Graphics -- started out in stealth mode, but by 1995 they had grown bolder: they began pushing money at Washington lobbyists. For legislative guidance they hired Lerach's archenemy, Bruce Vanyo from the Silicon Valley legal powerhouse Wilson Sonsini Goodrich & Rosati. In December 1995 they obtained nothing less than an act of Congress.
The committee that drafted the Private Securities Litigation Reform Act decided that Lerach and lawyers of his ilk had harmed the entire U.S. economy by routinely filing baseless, extortionate lawsuits, "whenever there is a significant change in an issuer's stock price, without regard to any underlying culpability of the issuer." Shareholders' attorneys had abused the legal system, Congress concluded, "to impose costs so burdensome that it is often economical for the victimized party to settle." As a remedy, it adopted the reform act, which was widely expected to rein in Lerach.
It has only been recently, though, that Silicon Valley has begun to see any results from its anti-Lerach campaign, and the picture is not entirely what the champions for reform had expected.
In one important respect, the reform act has dealt Lerach a major setback. It has made the jobs of shareholders' attorneys a lot more difficult, by requiring them to present hard-to-find facts that support their claims of corporate fraud. And increasingly, judges are tossing out fraud complaints that fall short of the new requirements. That trend threatens to topple a volume-driven business model that Lerach has successfully pursued for nearly two decades, in which his firm would swoop in on public companies at the least suspicion of foul play -- an earnings shortfall, for example, followed by a stock drop.
Indeed, in an interview in his sprawling San Diego office (picture a file room after a tornado), Lerach seems uncharacteristically daunted. Maybe the mayonnaise he heaped into his coleslaw at lunch hasn't sat right with him, but his usually rosy complexion is downright ashen. He reddens and roars only slightly even when asked about his critics, including the editorial board of the Wall Street Journal, which recently accused him and lawyers like him of "suing innocent companies with volatile share prices ... and extracting settlements from busy executives who can't afford to waste time in legal maneuvering." "I don't care what other people think about me, all right?" Lerach fumes. "It's that simple. I care about what I think of myself."
In the vast majority of cases he's pursued, Lerach has squeezed out settlements, which he has memorialized in a vast collection of Lucite cubes stacked around his office. He says he has long since lost count of the cubes, noting that "a lot of them have fallen behind the furniture." But his take from the settlements they represent is memorable: he has personally pocketed more than $100 million of the money handed over by companies and their insurers. His law firm, meanwhile, has soaked up nearly $700 million.
The biggest source of those gains has been from technology companies based in California. So when Lerach was abruptly shut out of court in a closely watched case there, in 1997, he was predictably apoplectic. The case was against Silicon Graphics (an active player in the reform movement), and the charges were practically identical to hundreds of complaints that had survived court challenges before the reform act was passed. Senior executives at Silicon Graphics had allegedly made false financial forecasts, concealed unfavorable internal developments, and wrongly profited from selling millions of dollars' worth of shares at artificially inflated prices just before disclosing disappointing earnings that caused the company's stock value to plummet.
In a major upset, federal judge Fern Smith threw out the suit, explaining that it failed to fulfill what she regarded as a new mandate of the reform act. Smith concluded that disgruntled investors faced a higher burden of showing not mere recklessness by corporate executives (as had been the case before) but specific facts suggesting that the executives deliberately intended to dupe the market. For Lerach the decision was devastating. He fretted at the time that if it was upheld on appeal, "private enforcement of the securities laws in this country will be mortally wounded."
Not only was Judge Smith's decision upheld, but last October it was also affirmed by judges in the Ninth Circuit -- the final hurdle before the U.S. Supreme Court. "It means that companies that simply miss their earnings expectations are not going to be hit with these lawsuits," predicts Bruce Vanyo, who defended Silicon Graphics.
Ironically, the very reforms for which Silicon Valley fought so hard have had the unintended effect of hastening the rush to the courthouse. Settlement costs have escalated as well.
Clearly, the Silicon Graphics ruling has transformed the nation's largest federal circuit -- encompassing nine western states -- from the easiest place to proceed with fraud suits into the hardest. And Lerach says he has reluctantly resigned himself to abiding by the "egregiously wrong" decision. In every other securities-fraud case that has made its way through the appeals process, the courts have followed the lead of the Silicon Graphics ruling in siding with company management. "You could look at the appellate decisions and conclude that we're getting slaughtered," Lerach admits.
But in the bigger picture, Lerach has clearly not been beaten. Even as judges whittle down his enormous inventory of cases, the number of new filings has not abated. In 1998 companies were sued at a rate of close to one a day, notes Joseph Grundfest, a former member of the Securities and Exchange Commission who now tracks securities litigation at Stanford University. Ironically, the very reforms for which Silicon Valley fought so hard have had the unintended effect of hastening the rush to the courthouse.
A requirement that lawyers post notice of pending securities complaints has, for example, functioned as a license to solicit disgruntled shareholders as clients. Posted on the Internet and with major wire services, the notices have drawn out thousands of small shareholders eager to join in a group effort to reclaim sudden losses -- almost before the lawyers have cobbled together a case. One law firm, Lerach competitor Weiss & Yourman, has even persuaded brokerage houses to send their clients letters describing stock-drop suits in the hope that traders will join complaints.
Shareholders' attorneys have also shifted the nature of a lot of their complaints. Whereas the reform act generally shields corporate management from fraud suits based on failed financial projections shared with analysts, it affords no such protection for alleged inaccuracies in routine financial statements. And that's where most of the action is now. According to data from PricewaterhouseCoopers, in 1995 only 25% of federal securities actions contained allegations of accounting fraud, as compared with 51% in 1999.
Of course, Lerach maintains that the shift toward claims of accounting fraud reflects nothing more than an increase in securities fraud, which he attributes partly to more public companies' linking executive compensation with quarterly earnings performance. "The dependence of corporate executives on stock-option trading and meeting short-term financial goals creates a powerful incentive to falsify results," he says, invoking an argument that has also recently found favor with senior staffers at the SEC.
A rash of major earnings restatements followed by gigantic settlements also supports Lerach's contention that securities fraud is at an all-time high. Traditionally, securities class-action suits have been settled for $5 million to $7 million; in the past two years the averages have been upset by several settlements in excess of $100 million. And last December, with investors claiming losses of more than $30 billion, Cendant Corp., together with its accountant Ernst & Young, set a record when it agreed to a joint settlement of $3 billion.
Such escalating settlement costs are, in part, another unanticipated outgrowth of reform. In an effort to eliminate lawyer-driven suits, the reform act called for courts to evaluate and appoint as lead plaintiffs the investors who had lost the most in an alleged fraud. Rather than allowing lawyers like Lerach to continue calling all the shots, the new law encouraged institutional investors to step to the front of the class, choose their own lawyers, and take charge of the case.
At first, institutional investors were leery of exposing themselves to the invasions and distractions of investigation. After all, every investor stands to collect a pro rata share of any recovery. Gradually, however, public financial institutions have come forward and assumed the position of court-appointed lead plaintiff, which ups the stakes for everyone. In the Cendant case, for example, the California Public Employees' Retirement System, the New York State Common Retirement Fund, and the New York City Pension Funds led the charge and obtained that unprecedented $3-billion recovery. Led by fund managers who are public servants, those institutions are now assuming an activist role in seeking to correct perceived wrongs in the market. "Institutional investors have lifted the bar on what they will accept in terms of settlement," says Alan Schulman, a former law partner of Lerach's, who anticipates that, down the road, private institutions such as mutual-fund companies may also jump into the fray. "That is something Silicon Valley didn't bargain for."
Owing in large part to his frequent vituperative attacks on corporate America, Lerach has so far not found much favor among institutional investors. "They're staying away from him in part because his attitude is insulting to them," comments Alan Salpeter, a partner with Mayer Brown & Platt in Chicago, who has defended accounting firms and other financial institutions.
Oddly, then, Lerach and his longtime adversaries in Silicon Valley now have cause to commiserate. "The megacases are going to be run by the big institutions, and the law firms that don't have large institutional clients are going to be out," says Schulman. Moreover, as financial institutions exert their newfound powers in securities-fraud complaints, public companies everywhere can expect stepped-up scrutiny from increasingly savvy investors -- and a steeper price to pay for missteps. With institutional investors in the mix, "it changes everything," worries Boris Feldman, who defends companies against securities complaints. "The institutions will kill us."
D.M. Osborne is a senior writer at Inc.
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