Class Action Securities Lawsuits: Winners and Losers
A wave of stock option backdating litigation against public companies who issued the options and the executives who benefited by exercising them, recently began hitting the American judicial system. Yet even as class, derivative and criminal actions filed by the Securities and Exchange Commission (SEC), the Department of Justice (DOJ), state Attorneys General and private plaintiffs, including investors, wind their way through the American justice system, the question arises: who benefits from these cases?
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The Private Securities Litigation Reform Act (PSLRA) of 1995 was enacted to curb abusive practices in securities class actions, promote transparency in corporate activities and prevent fraud. Although the number of suits filed in federal courts declined to the lowest annual level of 111 in 1996, the year PSLRA went into effect, the number of suits filed quickly rebounded, indicating it has not deterred plaintiffs’ attorneys from filing cases. Indeed, the Mid-Year Securities Fraud Class-Action Filings Report, released by the Stanford Law School Securities Class Action Clearinghouse in cooperation with Cornerstone Research, reveals that the annualized number of “traditional” securities fraud class actions filed between January and June 2006 decreased 31 percent, compared to 2005 levels. The 2006 annualized estimate is 123, down from 179 in 2005. The 61 filings through June 30, 2006, is the lowest level for any six-month period since 1996. It is also 36 percent lower than the 1996-2005 historical average of 194.
If PSLRA did not deter filings, it did change how much benefit investors receive when companies act fraudulently, according to research conducted by Anjan Thakor, Ph.D., finance professor and researcher at Washington University’s Olin School of Business in St. Louis, Missouri. Thakor’s analysis was conducted for the U.S. Chamber Institute for Legal Reform.
“The majority of participants in securities class action suits are institutional investors who trade more than $100 million a year. They don’t have to pay for any gains they made from selling the inflated stocks, and once they’re compensated for their losses, they actually come out ahead,” Thakor said. “Institutional investors are trading such a large volume. The net trading loss they suffer from buying inflated stocks is only 20 percent of their gross losses. Of the more than 2,300 firms we studied, 40 percent were shown to have realized a net benefit from the settlement proceeds.
“What’s worse is that the system is set up so that one group of shareholders ends up suing another group of shareholders. If I’m a shareholder who bought stock before the period where stocks were inflated, I can’t take part in the litigation, yet I will essentially be paying the settlement to those investors who did buy inflated shares,” continued Thakor. “It’s a process of taking money from one group of shareholders in the company and giving it to another for some wrongdoing by the company. Well, send the managers to jail. Fine them. Do whatever you want to do with them. But why should I be paying a shareholder when I’m not responsible for the problem?”
Additionally, because significant resources are used to pay lawyers and accountants handling the litigation, the actual transfer of the payment is not a neutral process. Investors end up with maybe three cents on the dollar after all the expenses are paid.
“The settlement doesn’t help the shareholders who paid the fine since they’re paying out of their own pocket,” Thakor said. “It doesn’t really help the shareholders who sued the company, who barely recover their losses. So who made the money? Large institutional investors handling more than $100 million in assets, the lawyers and the accountants.”
Thakor’s call to re-examine PSLRA in order to better punish those involved in the wrongdoing, echoes similar calls made nearly two decades ago regarding joint and several liability and tort reform at the state level.
The role of accountants in class action lawsuits is not a new issue. As a March 1990 interview with CPA Journal, Robert Mednick, then chairman of the American Institute of Certified Public Accountants (AICPA) Task Force on Accountants Liability, stated, “The number and size of lawsuits against accountants were increasing at an alarming rate. Accountants were, like many others, being swept along in a wave of lawsuits.
“In many of those lawsuits, somehow the courts and juries found someone to compensate an injured party for their loss,” he continued, explaining that in the 1970’s and 1980’s, joint and several liability laws at the state level allowed each negligent party to be held liable for the total damages suffered, regardless of how responsible they actually were for the loss. “Invariably, those with the ‘deepest pockets’ paid, particularly in the financial rubble of a bankrupt company. The accounting profession has kept its pockets well-lined as a protection to the public through the use of insurance. […] The irony is that accountants weren’t necessarily being sued by those directly hurt.”
Today, 37 states have enacted some sort of joint and several liability reform legislation which includes some form of proportionate liability, however, 23 of those states have retained joint and several laws under certain circumstances. In practical terms, these reforms limit the liability of accountants and accounting firms to their level of responsibility for the wrong doing.
More recently, Arthur Andersen’s role in the Enron collapse and scandals has brought more attention to the role of accounting in litigation, as well as additional regulation. In fact, the reduction in the number of class-action securities lawsuit filings is being attributed to the Sarbanes Oxley (SOX) Act of 2002 and the Class Action Fairness Act of 2005, by some experts. Whether SOX is the actual reason, or just one of many, will take years of additional study to determine.
“Law firms are finding fewer fact patterns to support claims," Joseph Grundfest, a Stanford Law School Professor, told Reuters. A former SEC member, he considers rising stock prices another factor in reducing the number of claims.
A study conducted by PricewaterhouseCoopers (PwC) revealed that law firms have been so busy with major class action securities cases such as Enron, WorldCom and others, that they have delayed filing new cases. The study also indicated that executives may be less inclined to push the legal limits after reading the tightened disclosure rules of legislation like SOX and watching colleagues going to jail as a result of wrongdoing uncovered by more vigorous regulatory and criminal investigation.
Howard Suskin, a corporate defense attorney, cites recent court decisions and legislation enacted by Congress for causing more cases to be dismissed early in the litigation process, according to the St. Louis Dispatch. The PwC study found that the average cost of securities litigation surged to $71.1 million in 2005, an increase of more than 150 percent from the previous year, even without the mega-settlements from the Enron and WorldCom litigations.
“Since the beginning of 2006, we’ve seen perhaps a greater decline than we’ve seen in the last decade. It has led to speculation that there is something to this,” Bruce Carton, vice president of Institutional Shareholder Services securities class-action practice, told the St. Louis Dispatch. “On the other hand, it’s six months of data. It’s probably going to take a year and a half to determine if it’s something that’s going to stick.”
Whatever the reason for the current decline in the number of class-action filings, some attorneys see another wave of securities litigation on the horizon. This time it won’t be against companies and executives but against the attorneys and auditors who advise them, especially those consulted regarding the mechanics and disclosure of offending options programs. Faulty advice, leading to the failure to adequately disclose, properly account for and remit appropriate applicable taxes on such programs, can place professional advisors squarely in the sights of shareholders, their attorneys and regulators.
Thus, while some may view accountants among the winners in class action securities litigation, it appears to be only a temporary condition, likely to unravel in the face of options backdating and other wrongdoing which can be laid at their door.