Shareholder Suits Make a Big Comeback
from May/June 2008
by Steve Flax
It looks like political pundits aren’t the only ones to get it wrong. Last summer Corporate Board Member, among others, looked at the drop in the number of class-action lawsuits in 2006 and predicted that the trend would continue. Instead, there was another spike in 2007. The last six months were particularly litigious, with shareholders suing 100 companies. That pushed the total for the year to 166 suits, compared with the 116 filed in 2006, according to Stanford Law School’s Securities Class Action Clearinghouse and Cornerstone Research.
So much for prognosticators who thought various reforms and improved corporate governance would continue to deter lawsuits. We had distinguished company in making that forecast, including Stanford law professor Joseph A. Grundfest, a former commissioner of the Securities and Exchange Commission. How does Grundfest explain what happened instead? He theorizes that the surge was driven by nonrecurring “systemic shocks,” such as the stock-options backdating scandals of 2006 and the subprime mortgage problems. If those sorts of cases are excluded from the total, he suggests, the “core” litigation rate “continues to be remarkably low.”
Some lawyers expect things to get worse, among them Jonathan C. Dickey of Gibson Dunn & Crutcher in New York City, who was among the minority predicting that the number of suits would rise in 2007. “There has always been a baseline of around a couple of hundred cases a year,” he says. “The effects of the subprime debacle are going to last a long time. I predict a lot more cases, in New York City and elsewhere.”
A recent Supreme Court ruling might have suggested otherwise. In dismissing a case brought by Stoneridge Investment Partners against Scientific-Atlanta Inc., which made set-top cable TV boxes, the court appeared to be protecting a company’s vendors and, by extension, its accountants, lawyers, and other advisers. But the decision could be construed by lower courts as enabling plaintiffs to sue such third parties, and Dickey believes that this could happen. It all depends on how the lower courts read the Supreme Court’s decision. Dickey also predicts that the subprime mortgage crisis will spawn additional litigation and that attorneys will bring more cases against major participants, such as lenders, along with an array of third parties, such as ratings agencies. “The floodgates of litigation may swing wide open against a variety of organizations that did not have any direct involvement in making false statements to investors, and who would at best be characterized as secondary actors,” he says. Backdated stock options portend more litigation too. Two settlements (UnitedHealth Group and Mercury Interactive) were for over $100 million. “As a result, 2008 may produce a number of settlements with significant monetary penalties,” says Dickey.
Meanwhile, derivative cases—those brought by shareholders in the name of the company—could mean even more lawsuits this year. “Some regard 2006 as probably the low-water mark [in the number of securities cases],” Dickey says, “but that’s a little misleading. The year also saw a boatload of derivative suits, very material numbers.” These weren’t added to the total of 2006 lawsuits, however. “Now, in the subprime [crisis], we’re seeing it all over again,” says Dickey. Indeed we are. Twenty-three case filings pertained to the subprime mortgage business in the second half of 2007. The roiling stock market could instigate more suits as well. “We’re in a tough market,” Dickey says, “so the litigation trend is likely to be up for a while.”
The incidence of securities lawsuits and the difficulty of managing them are exacerbated by what Dickey calls the opt-out phenomenon. Increasingly, major institutional investors such as pension funds are bringing their own lawsuits at the same time that they’re members of the class of shareholders bringing a class-action suit. “They get much bigger settlements than they’d get from being a member of the class,” says Dickey, “so they play a game of chicken with the company, holding out for a separate recovery.” Institutional investors can wait until the last minute, find out what sort of settlement the class members are going to get, and then opt out if the settlement they’ve made with the defendant is better. Large funds opted out of class-action suits against Enron, Tyco International, and WorldCom. “This is wreaking havoc on public companies,” Dickey notes. Now that funds know opting out produces better payoffs, companies can’t, as he says, put the genie back in the bottle.
What can directors do? “Have enough insurance,” says Dickey.
