By Wayne Schneider, General Counsel, New York State Teachers' Retirement System

Several years ago, the U.S. Court of Appeals for the Third Circuit opined in the landmark Cendant case that a fee request of class counsel based upon counsel's retainer agreement with the lead plaintiffs appointed pursuant to the 1995 Private Securities Litigation Reform Act should enjoy a “presumption of reasonableness.”

The federal securities class-action plaintiffs' bar have trotted this notion out ever since in support of their fee requests, no matter how excessive. In a recent decision, the Third Circuit appeared to indicate it has some second thoughts about its “presumption of reasonableness.” Perhaps securities investors can look forward to the day real soon when this notion disappears entirely.

Cendant was one of the early triumphs of 1995 Reform Act, and it still remains a significant landmark in the struggle for more reasonable attorneys' fee awards in federal securities class actions. However, certain bumps along the road led to the unfortunate coining of a “presumption of reasonableness,” which has plagued investors in class counsel fee determinations ever since.

Prior to the enactment of the 1995 Reform Act, it was usually the first plaintiff through the door of the courthouse who wound up serving as the class representative in federal securities class actions. Fortunately, the 1995 Reform Act did away with this practice by establishing a mechanism for appointing a lead plaintiff with the greatest stake in the litigation, rather than the one who was first. In Cendant, the Reform Act led to the appointment of the New York State Common Retirement Fund, the New York City Pension Funds, and the California Public Employees' Retirement System as lead plaintiffs. As part of their important service to the cause of investors, this impressive group of lead plaintiffs retained qualified counsel under a heavily negotiated retainer agreement.

The district court, however, felt the need to intervene in the pension fund group's decision as to who would represent them in their capacity as lead plaintiffs and under what economic terms. The court had the right to represent the lead plaintiffs auctioned off so as “to determine the lowest qualified bidder to represent the class as counsel.” As would prove fortunate, however, the court did accord the counsel previously selected by the pension funds a “right of first refusal” under which the counsel could agree to serve under the economic terms of the lowest bid in the auction. After the bids were received, the funds' counsel did exercise that right of first refusal and continued as their counsel in the action. (For more on the selection of class counsel, see: In re Cendant Corp. Litigation, 182 F.R.D. 144 (D. N.J. 1998).)

The case quickly settled for an astonishing amount, over $3.1 billion. But something went horribly wrong in matter of the counsel fee award, at least as far as investors were concerned. It turned out that, under the lowest qualified bid in the auction mandated by the district court, class counsel was entitled to a fee of some $262 million. But that fee happened to be some $76 million greater than the fee that would have been under the agreement originally negotiated by the public pension funds! The district court awarded the $262 million fee anyway.

On appeal, the Third Circuit quickly found that it was improper for the district court to have required the auction. (See Cendant, 264 F. 3d 201 (3d Cir. 2001).) “Although we believe there are situations under which the [Reform Act] would permit a court to employ the auction technique, this was not one of them,” the court ruled. The public funds had done exactly what the Reform Act had contemplated in conscientiously selecting counsel and negotiating hard on the fee. The fee award, therefore, had to fall and the case had to be remanded for counsel to submit a new fee application which, as the Third Circuit made clear, had to have prior approval of the pension fund lead plaintiffs as required under the original retainer agreement.

The Third Circuit could have ended its opinion on the matter of fees right there. But it did not. Instead, the court felt a need to “set forth the standards that the [district] court should follow in evaluating a properly submitted fee request in Reform Act cases...” It was at that point that the Third Circuit stated the review of fee applications in Reform Act cases “must be modified to take into account the changes wrought by the Reform Act. The biggest change, we believe, is that courts should afford a presumption of reasonableness to fee requests submitted pursuant to an agreement between a properly selected lead plaintiff and properly selected lead counsel.” The Third Circuit went on: “This is not to say, however, that this presumption cannot be overcome... We hold that the presumption will be rebutted when a district court finds the fee to be (prima facie) clearly excessive.”

Where did this come from? For its part, Congress certainly recognized the mere fact that a class member might be selected as lead plaintiff did not automatically invest that member with the skill and tenacity to negotiate an investor-favorable deal on fees. It would be great if the lead plaintiff did so, but there were no guarantees, as Congress fully recognized. That is why, as part of the 1995 Reform Act, in addition to the lead plaintiff procedures, Congress added 15 U.S.C. §78u-4(a)(6), which requires the court to ensure that class counsel fees do not exceed a reasonable amount. Congress was not prepared to believe the lead plaintiff mechanism by itself would be sufficient to protect the class from overreaching by class counsel on the matter of fees.

The Third Circuit seemed to recognize its newly minted presumption was at odds with that provision, at least acknowledging there was a “tension” between its presumption and the Reform Act's “overarching provision that requires the court to insure that counsel fees not exceed a reasonable amount.” But how could its presumption even be consistent with that admittedly “overarching provision”? The court's formulation of the presumption suggests the presumption is rebutted when class counsel's requested fee is “clearly excessive,” but suppose the requested fee is, on whatever basis, “moderately excessive” or “somewhat excessive.” Congress intended the 1995 Reform Act to bar the award of all unreasonable fees, even fees unreasonable by a little bit.

More important, why should there be any presumption in favor of class counsel's fee request? The court is supposed to act as a fiduciary to protect the interests of the absent class. Is there any other trust situation in which a court would entertain an argument that a vendor providing services to a trust is entitled to a presumption that its requested charge is reasonable? Wouldn't the burden on the vendor to prove its fee is reasonable? Indeed, doesn't 15 U.S.C. §78u-4(a)(6) necessarily place the burden on class counsel to show that its requested fee is reasonable? When Congress enacted the 1995 Reform Act, lawmakers clearly felt the fees then being requested by and awarded to securities plaintiffs' lawyers were disproportionate. Given that background, it cannot reasonably be believed Congress intended to give the same group of lawyers a benefit of the doubt on their fee applications going forward.

Given what has happened since, it is particularly ironic that class counsel in Cendant did not wind up with $262 million less $76 million. On remand, the fee application submitted to the district court was for $55 million, about 20 percent of the previous award disapproved by the Third Circuit and just 1.7 percent of the settlement fund. The original retainer agreement, in fact, only proved to be a ceiling on class counsel fees, from which the public pension plans were able to negotiate class counsel down to a fee that was even more favorable to the class.

Use of the Presumption by Class Counsel
Unfortunately, federal securities class action lawyers have been quite happy to seize upon the Third Circuit's “presumption of reasonableness” as a new weapon in their arsenal to beat back objections to their fee requests in the post-Reform Act era. For example, in the cases in which my system has objected to fee requests, which it believed to be excessive, class counsel has invariably trotted out the “presumption of reasonableness” as their argument of choice. Indeed, class action lawyers love the presumption because they see it as inviting a court to determine not whether they have carried their burden under the Reform Act of proving their requested fee is reasonable, and not excessive, but to determine only whether the precise objections raised by objecting parties “clearly” establish their requested fee is unreasonable. As they would have it, their requested fee must be determined to be reasonable under the “presumption” unless proven otherwise.

Their position, as discussed above, is flatly contrary to the intent of Congress in enacting the 1995 Reform Act that the courts rein in attorneys' fee awards and put the onus on class counsel to demonstrate their fees are reasonable. In other words, going forward, the courts were to accord even more protection to the class from excessive fee awards in federal securities class actions, not less. Fortunately, some courts have not bought into these arguments. For example, in the Bristol-Myers Squibb litigation, U.S. District Judge Loretta Preska of the Southern District of New York remarked: “Despite the improvements intended by the [1995 Reform Act], plaintiffs in common fund cases [generally remain] mere ‘figureheads,' and the real reason for bringing such actions [remains] ‘the quest for attorneys' fees.'” In other words, there is no basis to believe lead plaintiffs as a group are doing such a good job in negotiating class counsel fees as to warrant a presumption in favor of their fee requests.

The Third Circuit's AT&T Decision
Given the constant invocation by the plaintiffs' class action bar of the Third Circuit's “presumption of reasonableness,” I read with great interest the Third Circuit's recent decision in the AT&T securities litigation (2006 U.S. App. LEXIS 18279 (3d Cir.)). The decision resolved the appeal of certain objectors to a fee award representing 21.35 percent of a $100 million settlement. Significantly, the case had proceeded to the point where a jury had been empanelled, opening statements had been given, and 11 witnesses had been called by the plaintiffs. The requested fee represented 1.28 times class counsel's lodestar. The objectors, nonetheless, persevered, pointing to the 15.1 percent average for fee awards in class actions resulting in settlements over $100 million.

Although the court affirmed the fee award, I believe the most important part of the decision may be its discussion of the “presumption of reasonableness.” Apparently, the Third Circuit had been mulling over the problem of according a presumption of reasonableness to a fee negotiated between a lead plaintiff and class counsel when there is no assurance the lead plaintiff had vigorously and aggressively sought the best possible deal on fees. As the court noted:

We now emphasize that the presumption of reasonableness set forth in Cendant does not diminish a court's responsibility to closely scrutinize all fee arrangements to ensure fees do not exceed a reasonable amount. We caution against affording the presumption too much weight at the expense of the court's duty to act as ‘a fiduciary guarding the rights of absent class members.'

Later on, in footnote 7, the Third Circuit reiterated its new view of the “presumption of reasonableness,” in case a reader did not get it the first time around: “We again caution courts to refrain from granting this presumption too much weight.”

The Third Circuit's reconsideration of its “presumption” is certainly timely. While large public sector pension plans have generally worked hard to reduce class counsel fees in those cases where they serve as lead plaintiffs, there is no evidence that other lead plaintiffs as a group have been significantly reducing those fees.

In fact, the evidence appears to be that many lead plaintiffs (other than large public sector pension plans) are falling down on the job. One telling example is the recent 25 percent fee request in the Qwest Communications case, which settled for $400 million. No public sector fund was serving as lead plaintiff and, as could almost be predicted, the Qwest fee request is far above the requests in recent cases settled by public sector funds, such as Raytheon (a $460 million settlement and a 9 percent fee request), Dynegy (a $473 million accord and a 9 percent fee request), and Waste Management (a $457 million settlement and a 7.9 percent fee request).

Unless there is conclusive proof that all lead plaintiffs as a group are negotiating the kind of highly favorable fee arrangements being achieved by public sector funds, there is no basis for a presumption that any given requested fee is reasonable. The Third Circuit's reconsideration of the presumption is quite welcome; hopefully, it will be a quick prelude to the presumption's complete repudiation.

The views expressed are solely those of the author and do not necessarily represent the views of the system by which he is employed.

TENTATIVE SETTLEMENTS

Central Freight Lines
Central Freight Lines announced an oral agreement with investors to settle their securities claims for $2.6 million. The class action lawsuit was filed in June 2004 in the U.S. District Court for the Western District of Texas. Investors who purchased the company's common stock from the time of its initial public offering through March 17, 2005, are expected to be eligible to take part in the settlement.

Central Freight Lines is a trucking company operating in the Southwest, Midwest, and Northwest regions of the United States. As of Dec. 31, 2005, Central had a fleet of 1,831 tractors and 8,066 trailers.

For more details, see the SCAS Web site by clicking here.

Enron (Arthur Andersen, Kirkland & Ellis)
Two additional defendants have agreed to add $86 million to the Enron settlement fund. Arthur Andersen, which was Enron's auditor, and Kirkland & Ellis, a law firm that advised the energy company, will contribute $72.5 million and $13.5 million, respectively. Investors originally filed suit in October 2001 in the U.S. District Court for the Southern District of Texas. Investors in Enron or Enron-related entities between Sept. 9, 1997, and Nov. 27, 2001, are expected to be eligible to take part in the settlement.

Enron, which collapsed into bankruptcy in December 2001, was once the world's largest energy trader and the largest buyer and seller of natural gas and electricity in the U.S.

For more details, see the SCAS Web site by clicking here.

McLeodUSA
McLeodUSA and other defendants have agreed to pay $30 million to settle a class action lawsuit filed in January 2002 in the U.S. District Court for the Northern District of Iowa. Investors who purchased McLeodUSA stock between Jan. 3, 2001, and Dec. 3, 2001, are expected to be eligible to take part in the settlement.

McLeodUSA offers telecommunication services to residential and business customers.

For more details, see the SCAS Web site by clicking here.

DISMISSALS

Cray
A class-action lawsuit that was filed in May 2005 in the U.S. District Court for the Western District of Washington against Cray has been dismissed. The lawsuit was filed on behalf of purchasers of Cray common stock from Oct. 23, 2002, through May 9, 2005.

Cray designs, develops, manufactures, markets, and maintains high-performance computer systems.

For more details, see the SCAS Web site by clicking here.

IntraBiotics Pharmaceuticals
A class-action lawsuit that was filed in July 2004 in the U.S. District Court for the Northern District of California against IntraBiotics has been dismissed. The lawsuit was filed on behalf of investors who purchased the company's common stock from Sept. 5, 2003, through June 22, 2004.

IntraBiotics is a pharmaceutical company that develops anti-microbial drugs.

For more details, see the SCAS Web site by clicking here.

iPass
A class-action lawsuit that was filed in January 2005 in the U.S. District Court for the Northern District of California against iPass has been dismissed. The lawsuit was filed on behalf of purchasers of iPass stock between April 22, 2004, and June 30, 2004.

The company is a provider of software-enabled enterprise connectivity and endpoint management services for remote and mobile workers.

For more details, see the SCAS Web site by clicking here.

Funds recently have been recently disbursed (or approved for disbursal) in the following cases:

• Crossroads Systems
• Sunglass Hut International
• Bank One (First Chicago NBD)
• Carnival
• Charter Communications
• Ultralife Batteries
• Creditrust

New Study Details Investor Losses From Backdating
By Ted Allen, Director of Publications

A new study by University of Michigan researchers concludes that investors have incurred significant losses at companies that have been accused of backdating executive stock options.

The researchers analyzed 48 firms that have been implicated in backdating and found that investors lost an average of 8 percent in market value (or $510 million per firm) during the 21 days around the disclosure of backdating allegations, according to Compliance Week. At most of these firms, the losses far outweighed the potential gains ($600,000 per company on average) that executives and directors could have received from backdating options. (The study didn't look at the potential gains that employees might have received from backdated options.)

“For a small gain to themselves, [executives are] putting their shareholders at huge risk,” M.P. Narayanan, one of the study's authors, told Compliance Week. “Shareholders might have been better off if executives just asked for more money.”

At those 48 companies, investors suffered abnormally negative returns at 35 firms, the researchers found. The most significant (market-adjusted) declines were at Vitesse Semiconductor (57 percent) and Jabil Circuit (31 percent).

The researchers also found that most of the investor losses (5 percentage points of the average 8 percent drop) occurred in the nine days before the first public disclosure of backdating accusations. According to the study authors, “this finding suggests that some insiders or hedge funds may be receiving word of the likely filing of backdating complaints and either selling or shorting the stock in advance.”

The study may prompt some lawyers for investors to investigate their potential client losses in the weeks prior to the first public disclosure, rather than base their claims on a date right before the public disclosure, C. Hunter Wiggins, a partner with Sonnenschein Nath & Rosenthal, told Compliance Week.

“If a huge stock price drop occurred before the public disclosure price, plaintiffs' attorneys might try to use a date earlier than the traditional date immediately before public disclosure,” Wiggins said. “They won't want to leave 75 percent of the damages on the table.”

Bloomberg News estimates that investors collectively have lost $7.9 billion in market value from the option-timing scandal. Of the 117 firms that announced option investigations before Aug. 31, two-thirds suffered market value declines the next day, which averaged 2.6 percent.

Some investors have chosen to file derivative lawsuits against corporate officers and directors after concluding that they had not suffered sufficient investment losses from alleged option manipulation to mount a viable class-action case. So far, 17 companies have been hit with securities class actions over option grants, according to SCAS data. Meanwhile, more than 80 companies now face derivative lawsuits arising from their option practices, according to The D&O Diary, a Web log maintained by Kevin LaCroix of OakBridge Insurance Services.

Another Appeals Court Rules on Filing Deadlines
Another federal appeals court has ruled that the Sarbanes-Oxley Act of 2002 does not revive securities claims that expired before the law was enacted.

The legislation extended the filing deadlines for federal securities lawsuits to two years after the discovery of the alleged violation or five years after the violation, whichever is earlier. Although Sarbanes-Oxley stated that it “shall apply to all proceedings . . . commenced on or after” July 30, 2002, the law was unclear over whether Congress intended to revive claims that had expired under the old deadlines (one year after discovery or three years after the violation).

In a Sept. 11 opinion, the U.S. Court of Appeals for the Fifth Circuit joined the majority of U.S. appellate courts (including the Second, Third, Fourth, Seventh, and Eighth Circuits) in holding that the new filing deadlines should not be applied retroactively, according to The 10b-5 Daily, a Web log maintained by Lyle Roberts, a partner with LeBoeuf, Lamb, Greene & MacRae in Washington. The Fifth Circuit hears appeals from federal courts in Texas, Louisiana, and Mississippi. The Atlanta-based Eleventh Circuit remains the only dissenter, Roberts said.

CalPERS Named Lead Plaintiff in UnitedHealth Litigation
The California Public Employees' Retirement System (CalPERS) has been named the sole lead plaintiff in the securities class-action litigation against UnitedHealth Group.

“We appreciate the opportunity to serve as lead plaintiff in this action against UnitedHealth,” Peter Mixon, general counsel of CalPERS, said in a Sept. 14 press release.

The pension fund said it was appointed lead plaintiff by U.S. Magistrate Judge Franklin L. Noel in St. Paul, Minnesota. The judge appointed the law firm of Lerach Coughlin Stoia Geller Rudman & Robbins as lead counsel for the class.

CalPERS and other investors contend that UnitedHealth, the second-largest U.S. health insurer, misled shareholders about its stock-option and compensation practices. The investors also claim the company allowed executives to set their option grant dates when share prices were low and improperly “spring-loaded” options. The Minnesota-based company delayed filing its second quarter results while it considers whether to restate its financial statements.

CalPERS, the largest U.S. public pension fund, said it holds 6.6 million UnitedHealth shares that are valued at $360 million.

SEC Settles First SOX Case Against a Foreign Issuer
On Sept. 14, the Securities and Exchange Commission announced a settlement of an enforcement action against TV Azteca, a Mexico-based company, and Chairman Ricardo Salinas Pilego and former CEO Pedro Padilla Longorio. According to press reports, the enforcement lawsuit is the first case under the Sarbanes-Oxley Act brought by the SEC against a foreign issuer.

As Kevin LaCroix noted in his D&O Diary Web log, “a continuing debate surrounding the Sarbanes-Oxley Act has been the extent to which the act may discourage foreign companies from listing their shares on U.S. securities exchanges. Enforcement activity against foreign issuers undoubtedly will influence the relative attractiveness of U.S. exchanges to foreign companies.”

Under the settlement, Salinas Pilego agreed to pay $7.5 million while Padilla Longorio agreed to pay $1 million to compensate investors.