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The world of the boardroom has been destabilized by the recent decision of the lead plaintiff in the WorldCom securities class action to insist upon personal liability on the part of WorldCom’s outside directors as the price of a settlement. The settling outside directors were required to pay personally “over twenty percent of those directors’ cumulative net worth, excluding their primary residences, retirement accounts and jointly held assets”-or $18 million. See In re WorldCom Inc. Sec. Litig., 2005 U.S. Dist Lexis 1805, at 18 (S.D.N.Y. Feb. 10, 2005). But the directors’ insurance proceeds were not exhausted. Thus, the lead plaintiff preferred imposing personal liability on directors to maximizing the size of the settlement. This explicit agenda of requiring a personal contribution has traumatized outside directors, and it is being copied by other public pension funds, which are offering bounties to class counsel in the form of higher fee awards if they can compel directors to contribute personally to a class action settlement. But this is only half the story. Far less attention has been given to the fact that the WorldCom court rejected this settlement. U.S. District Judge Denise Cote declined to approve the settlement because she found it violated the rights of the nonsettling defendants. Specifically, the settlement required her to approve a “reduction formula” that would have reduced the liability of the nonsettling defendants in WorldCom only by the aggregate “financial capability” of the settling director defendants (i.e., the total amount that they could be made to pay given their limited assets). This negotiated provision conflicted, she found, with the express language of � 21D(f)(7) of the Securities Exchange Act of 1934, which was added by the Private Securities Litigation Reform Act of 1995 (PSLRA) in order to protect directors by substituting a system of proportionate liability for the system of “joint and several” liability that governs other defendants under the Securities Act of 1933. Her interpretation is legally unassailable, but its ironic implications are, as she recognizes, to “make it extraordinarily difficult for outside directors to settle Section 11 claims” in a partial settlement. In re WorldCom Inc. Sec. Litig., 2005 U.S. Dist. Lexis 1805, at 33. Nor does she overstate when she writes that “[t]he judgment reduction provisions of [� 21D(f)(7)(B)] significantly undermine the PSLRA’s protection of outside directors, because it . . . gives them little opportunity to reduce their risk of potentially devastating personal liability.” Id. at 49. Outside directors now face a dual crisis Thus, there is a dual crisis for outside directors. Plaintiffs are stalking them, insisting on personal liability, and the proportionate liability system intended by the PSLRA to protect outside directors perversely precludes partial settlements. In WorldCom, the lead plaintiff insisted on a 20% contribution from each director (or $18 million in total), even though the insurance coverage available to the defendants was not exhausted and as much as $85 million remained. Id. at 31. The lead plaintiff had the leverage to force the directors to contribute personal assets because the potential liability dwarfed their insurance coverage. The requested � 11 damages for WorldCom’s 2000 and 2001 bond offerings alone came to $17 billion. Id. Thus, unless the directors settled on a basis acceptable to the lead plaintiff, they could have been forced to face the prospect of a bankrupting multibillion-dollar liability well in excess of their insurance coverage. On this basis, the lead plaintiff can seemingly demand whatever it wants. But if the lead plaintiff wants to maximize deterrence, rather than the size of the recovery, by insisting on personal liability, as in WorldCom, do defendants have any legitimate response? Under � 21D(a)(3)(B) of the Securities Exchange Act, the lead plaintiff is presumptively made the person or group that “has the largest financial interest in the relief sought by the class.” But this presumption is subject to rebuttal if it can be shown that the presumptive plaintiff with the largest stake “will not fairly and adequately protect the interest of the class.” Similarly, the class cannot be certified under Federal Rule of Civil Procedure 23(a)(4) unless the court finds that the lead plaintiff will “fairly and adequately” protect the interests of the class. But is it “fair and adequate” representation to spurn a likely larger recovery in order to obtain a personal contribution from the director defendants? If the lead plaintiff’s fiduciary obligation to the class is to maximize the recovery for the class, an insistence on obtaining personal liability at the expense of the aggregate recovery may render the lead plaintiff an inadequate representative. At present, there is little law on this point. In general, a district court approving a settlement is required to estimate the action’s litigation value and then determine if the settlement is a reasonable approximation. See Reynolds v. Beneficial National Bank, 288 F.3d 277, 279-83 (7th Cir. 2002). But this is not an exact science, and it may be difficult to show how much recovery was sacrificed in return for personal liability. Also, the issue here is not significantly different from the issue that arises when a class or a derivative action is settled primarily for nonpecuniary relief, such as corporate governance reforms. Some courts have upheld even entirely nonpecuniary settlements involving only governance reforms in cases where the evidence of fiduciary abuse was strong. See Grenada Investments Inc. v. DWG Corp., 962 F.2d 1203 (6th Cir. 1992). A policy argument can be made that, because shareholders are diversified, they benefit from the increased deterrence that personal liability presumably generates. Arguably, it may be a reasonable tradeoff to sacrifice some financial recovery for such deterrence. Conversely, given the uncertainties surrounding whether general deterrence ever really works, it is likely that, if asked, investors would prefer money to punishment. Soon courts will have to face this issue. The proportionate reduction trap The WorldCom settlement collapsed when the nonsettling defendants properly objected that, under � 21D(f)(7) of the Securities Exchange Act, they were entitled to have any verdict or judgment against them reduced by “an amount that corresponds to the percentage of responsibility” assigned by the factfinder to the settling defendants. Once it saw how expensive the partial settlement with the outside directors could now be to it, the lead plaintiff immediately exercised its right to cancel the settlement agreement. To illustrate, let us assume that the jury in the WorldCom case finds liability in the amount of $10 billion (which is well less than the amount actually sought). Next, assume that the jury decides that the “percentage of responsibility” of the outside directors was 30%. Under � 21D(f)(7)(B)(i), the liability of the other nonsettling defendants (e.g., the underwriters, the corporate officers and the accountants) must be reduced by 30%-or $3 billion. Because these other defendants have joint and several liability under the express terms of � 11(f)(1) of the Securities Act, this amounts to a major windfall for them. For example, if the WorldCom court had accepted the settlement agreement and found the “financial capability” of the settling directors to be, say, $100 million, then the liability of the nonsettling defendants would have been reduced by only $100 million, not by the $3 billion that under the court’s decision must be subtracted. This $2.9 billion difference was too much for the lead plaintiff to accept, and hence it backed out. As the court recognized, � 21D(f) may give the nonsettling defendants more than they deserve. Had the settling defendants instead gone to trial, the most they could have contributed would have been $100 million (i.e., their total resources), and the other defendants would have been jointly and severally liable for the balance under � 11(f) of the Securities Act. As a result, plaintiffs cannot afford to settle with the outside directors pretrial because it could cost plaintiffs too much in terms of the liability of deeper-pocketed defendants, such as underwriters. This undermines the entire point of giving outside directors proportionate liability, which was to reduce the pressure on them. Mismatch between two acts causes the problem In overview, this problem arises because of a mismatch between the Securities Act of 1933 and the Securities Exchange Act of 1934. Under the former, the defendants other than the outside directors face joint and several liability, but still receive a proportionate reduction under � 21D(f)(7) of the Securities Exchange Act equal to the outside directors’ “percentage of responsibility” in the event that the outside directors settle. This is a windfall, because in the event of a trial, the other defendants could not expect the director defendants to contribute more than their total assets. In contrast, in a Rule 10b-5 case, plaintiffs will still settle because all defendants are subject to the same proportionate liability system, and none faces joint and several liability, unless they were knowing participants in the fraud. Essentially, there are two legislative ways to remedy this problem: The Securities Exchange Act’s proportionate liability system could be extended to all defendants in a Securities Act case, or, more simply, the reduction in liability for the nonsettling defendants in a Securities Act case could be limited to a pro tanto deduction for the actual settlement paid by the outside directors. Then, plaintiffs would incur no risks in settling with the outside directors. The PSLRA has backfired. Until its unintended mismatch is cured, outside directors will likely face trial in � 11 cases. John C. Coffee Jr. is the Adolf A. Berle Professor of Law at Columbia Law School and director of its Center on Corporate Governance.

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