You know the feeling. If you invest like I do, you really know the feeling. Eventually one of those maligned, misunderstood companies that you own is going to be smacked with a class action securities lawsuit. Cisco's (NASDAQ:CSCO) faced the music in the last few years. So has McDonald's (NYSE:MCD). Companies that are facing ongoing shareholder actions include Royal Dutch (NYSE:RD), NovaStar (NYSE:NFI), LeapFrog (NYSE:LF), and Merck (NYSE:MRK). And usually it isn't just one suit, but eight or nine, filed in rapid succession, generally accompanied by statements that a company has committed a fraud leading to a stock price decline. It's not for nothing that a Florida judge once called securities class action attorneys "squeegee boys."
Safe Harbor Provisions be damned, eventually nearly every single publicly traded company in America is going to have to endure a class action lawsuit or two -- it's like a cost of being public. Depending on your perspective, and even depending on the situation, the class action lawyers are the white knights come to rescue the hapless and downtrodden, or they are the collective causes of every evil from athletes' foot to Muzak to the designated hitter -- they're bloodsucking parasites who serve as an atrocious impediment to American competitiveness. And depending on your experience with them, you're not likely to want to hear that they have any of the countervailing qualities.
Angels and devils in a convenient package
Guess what? They're both. For those who believe that class action securities lawyers are completely evil, please note that these were the very people who extracted a multibillion-dollar payment from Cendant (NYSE:CD), a predecessor of which had deceived shareholders for more than a decade while insiders took out hundreds of millions of dollars. They caused Al Dunlap to settle for $15 million over his role as CEO of Sunbeam when its books were rotten to the core. They also are the same people to whom the victims of fraud at Enron and WorldCom looked to secure relief for their losses from fraud. At one point, more than 60 class action suits were filed against Enron and its officers. How many of these suits would you suggest were not justified, when you consider that the company claimed to have more than $1.2 billion in shareholder equity that in actuality had disappeared down a rathole?
For those who believe that class action lawyers are saviors to those taken advantage of by unscrupulous managements, kept boards, and shady investment bankers, note once again that the Private Securities Litigation Reform Act (a.k.a. "Safe Harbor"), passed in 1995, came to be simply because class action firms dropped suits on companies for little more than the high crime of having a stock that had dropped.
With record numbers of companies filing restatements and a widely noted decline in accounting report quality, there should be no doubt that a large number of companies getting sued by shareholders richly deserves it. Our financial system, with all its checks and balances, continues to reward fraudulent behavior much more efficiently than it does penalize it. And the same Safe Harbor Act that was designed to limit frivolous class action suits -- the notorious "fraud by hindsight" cases that ran rampant in the early 1990s -- has also created an environment that explains some of the behavior among class action firms today.
"We fudged our numbers" isn't protected
In February, El Paso (NYSE:EP) disclosed that it would have to write down a substantial amount of its proven reserves, essentially due to the fact that someone at the company confused the word "proven" with "nonexistent." Within two days, notices of lawsuits against the company came streaming across the wire.
A cynic might wonder how the firms filing these suits "on behalf of shareholders" would know anything at all about the companies they're serving notice against in such a short period of time. A deeper cynic still might wonder whether the firms had advance notice of the action that would take down a company's shares.
Honey, it's not how it looks!
The answer to both is "they didn't need to." Even students of jurisprudence think of the law as being a deliberate process. Thanks to the Safe Harbor Act, securities class action suits are more like "Mad Libs." How did so many firms file so fast? It's not complicated -- the firms have a cookbook with all of the various complaints completed. To file, all they need to do is slap in a few salient details. The firms then worry about building a case, and more importantly, attracting plaintiffs. The facts don't matter yet; speed does. Because in the end, regardless of how many law firms file suit or attract plaintiffs, the courts will require the suits to be combined into a single case, with the shareholder who has lost the most serving as lead plaintiff. And that shareholder can choose whichever law firm he or she wishes to serve as lead firm for the entire class.
Even the financial media get this wrong. The rash of shareholder lawsuits you see filed against a Nokia (NYSE:NOK) or an El Paso aren't signs of multiple shareholder groups filing complaints. They're advertisements from these firms in search of the big-fish defendant to serve as lead plaintiff. Read them closely, you'll see: Blabbedy Blah firm "announces that a lawsuit seeking class action status has been filed in the United States District Court ... on behalf of all persons who purchased the publicly traded securities.... If you are a member of the class, you may ... request that the Court appoint you as lead plaintiff of the class.... The securities laws require the Court to consider the class member(s) with the largest financial interest as presumptively the most adequate lead plaintiff(s)."
These notices, by the way, are also outgrowths of the Safe Harbor Act, which requires that a notice of impending securities complaint be filed. Firms use this requirement essentially to trawl for plaintiffs. And because we're talking about a group of people who have usually just suffered substantial declines in their portfolios, these aren't exactly waters bereft of potential.
In the end, though, these companies won't have to deal with a swarm of class action suits. They'll have to address one. But this doesn't stop reporters from mentioning these class action suits like they're all independent events. They're not, and the firms haven't even begun to make their cases when the suits are filed. They're placeholders, ones that can be extremely lucrative for the firms.
It's easy to be cynical about the methods and impact of the class action firms. Since the Safe Harbor Act addresses predictions, but not other communications like financial statements, many corporate advocates call for a strengthening of the protections to make it still harder for the class action firms to ply their trade. But in this regard, companies are their own worst enemies. In an age when rampant executive compensation and rising instances of corporate fraud keep investors' (read: voters') distrust and anger at steady levels, there is little to no taste on Capitol Hill to make it harder for those same shareholders to successfully sue. Basically the sociopathic behavior of many corporate executives -- who ensure that their paydays are substantial regardless of performance -- guarantees that the abuses of the plaintiffs' bar will continue as well. I wish I could believe that they'd keep each other in balance, but it's a false dichotomy, as tendencies for excess from each come not out of each other's pockets, but out of shareholders' portfolios.
Bill Mann owns shares of McDonald's. Taking a cue from the disaster in corporate governance following Congressional intervention in 1993, Bill would consider dumping every American company that doesn't expense stock options should Congress get in FASB's way this time around.
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