Looking at the Logic Behind Shareholder Class-Action Suits

[WSJ_law_blog]

LBers, we’re going to wrap up the week with a post that’ll stick with you a little longer than most; that you’ll still be thinking so hard about on your drive home outta the Beltway or down the 405 that you’ll lose all track of time and miss your exit.

The topic: shareholder class actions. The publication: Business Week. The writer: noted legal scribe Michael Orey. The article’s whereabouts: here.

Orey uses Judge Rakoff’s recent ruling in the BacMerSaga* to ask a broader question about the logic behind shareholder class action suits. Writes Orey:

Rakoff said the SEC didn’t adequately explain why it had not pursued charges directly against the bank executives or lawyers allegedly responsible for issuing “false and misleading” proxy statements and instead targeted the corporation. In his order nixing the deal, he called it “unfair,” “unreasonable,” and “inadequate.” Rakoff’s ruling prompts a question that seems to garner little attention outside a small circle of academics: Why do we tolerate the same perverse approach and empty outcomes in the resolution of private shareholder class actions?

Orey’s critique of shareholder securities suits hinges on two main points. The first: that the suits punish the wrong group of people for alleged wrongdoing: current shareholders. He writes:

Shareholder claims almost all involve “aftermarket” investors, who bought and sold from one another in the secondary market, not directly from the corporation through a stock offering. So BofA investors who sold for a loss after Merrill Lynch’s financial plight became known are now seeking payment from BofA investors who didn’t sell or who acquired their shares after the price drop. . . .

The age-old purpose of fraud claims is to force a wrongdoer to cough up ill-gotten gains to the person deceived. Shareholder lawsuits do no such thing.

Orey’s other (but related) critique: that such suits don’t deter malfeasance:

The contradictions and costs of shareholder class actions as a means to compensate investors for fraud-related losses might be deemed acceptable if they effectively served another key social goal—deterring fraud in the first place. It’s hard to find anybody (outside the plaintiffs’ bar) who thinks they do.

Why? Because the costs of litigation, including settlements and attorneys’ fees, are generally paid for by the corporation’s shareholders, not the executives who committed the fraud. And settlements of investor class actions are so routine, either because they are costly to fight or because a company doesn’t want to risk a potentially massive jury verdict, that they carry little or no opprobrium.

Orey concludes thusly:

Any comprehensive reform of the financial system should include a fundamental reconception of shareholder lawsuits. Rather than compensating secondary-market investors, their aim should be to deter fraudulent conduct. That means directors and officers need to be far more than just titular defendants—they need to have skin in the game.

LBers, any thoughts?

* Yes, we’ve decided to go with this 10-letter word — BacMerSaga — to refer to the situation concerning the SEC’s recent settlement with Bank of America over Merrill Lynch bonuses which was scotched by Rakoff. It’s to be pronounced “back-MERCE-uh-guh.”

I think they benefit primarily the lawyers and NOT the shareholders.