Shareholder Lawsuits Drop In '05, But Will It Last?

Has Corporate America finally cleaned up its act? The number of class-action shareholder lawsuits filed last year fell to only 176, a 17 percent drop from 2004 and well below average for the last decade, according to a new report from Stanford Law School and Cornerstone Research.

Investor losses related to these lawsuits decreased by a third, to $99 billion last year from $147 billion in 2004. It was also about half the total in each of 2001 and 2002.

Stanford Law School Professor Joseph Grundfest, director of the Securities Class Action Clearinghouse and a former Commissioner of the Securities and Exchange Commission, cites two likely reasons for the falloff: lawsuits arising from the dramatic boom-and-bust cycles of the stock market in the late 1990s and early 2000s are now largely resolved, and improved governance in the wake of the Enron and WorldCom frauds may have reduced the actual incidence of fraud.

Latham

Many securities lawyers, however, don’t place much significance on the report’s findings. “It’s not a trend yet,” says John Latham, partner with Alston & Bird and a member of the firm’s Securities Litigation and Capital Markets groups.

“I do not attribute it as significant,” agrees Stuart Grant, partner of Grant & Eisenhofer. “The bottom 10 percent or 15 percent of lawsuits is not being brought. We’re seeing fewer garbage cases that shouldn’t have been brought.”

Bruce Carton, the Institutional Shareholder Services' vice president who heads their Securities Class Action Services group, wrote in a recent 'blog entry that the 2005 decline of 37 cases does not appear to be historically significant. "To the contrary," writes Carton, "it appears to be directly in line with the pattern of the last 9 years."

Even so, Darren Robbins, co-founder of Lerach Coughlin Stoia Geller Rudman & Robbins, contends that the falloff underscores the success of the Private Securities Litigation Reform Act of 1995. The law gave companies more latitude when defending against suits, leading to a surge in dismissals, he says.

The PSLRA requires plaintiffs pleading a securities fraud case to describe their allegations in detail. Under this standard, shareholders can’t simply claim that, for example, since a company restated results and the stock subsequently fell, the top executives must have known beforehand that the numbers were wrong.

In addition, plaintiffs must demonstrate falsity and scienter—an intent to defraud. “It’s exactly what the PSLRA was designed to achieve,” Robbins says, referring to the falloff of what he considers “frivolous” suits.

Grant

“There is no money for plaintiff law firms to take marginal lawsuits,” Grant adds. “But the good quality cases are still with us.”

A number of experts also attribute the falloff in lawsuits to cooling volatility in the stock market in recent years—and, apparently, a more forgiving mood from investors.

As proof, some attorneys point to recently published data from research firm Glass, Lewis & Co. that showed 971 earnings restatements in the first 10 months of 205 alone, compared with 619 for all of 2004. Glass Lewis says it wouldn’t be surprised if restatements for the full year approach 1,200.

Undoubtedly, at least some of those restatements today will become the class-action suits of tomorrow. Yet, “last year, the reaction [to these restatements] in the market was muted,” says Gerry Fujimoto, a partner at Deloitte & Touche’s financial advisory services practice and a specialist in defending class-action suits. He asserts that if the market were more volatile, the stocks of many of companies that restated earnings would have plummeted, and consequently spawned a rash of lawsuits.

Settlements are also taking longer to resolve, Latham says. One big reason: many cases in talks right now potentially involve huge sums of money and require much negotiation among insurance carriers, institutional investors, and courts reviewing settlement deals more carefully. “There are a number of cases out there trying to work through [the process],” he says..

The SOX Effect?

So will the heightened awareness of fraud created by the Sarbanes-Oxley Act lead to fewer shareholder lawsuits in the future? Even lawyers skeptical that the Stanford research heralds a new era of less litigation concede that SOX and other recent corporate governance rules will lead to less misconduct.

“Maybe it has had an effect,” Robbins says. SOX’s certification requirements in particular “have some sort of a therapeutic effect,” adds Robbins. “It makes people think twice.”

LITIGATION MARKET

The excerpt below is from Securities Class Action Case Filings 2005: A Year In Review, published by Cornerstone Research, January 2006:

In 2005 there were marked increases in the percentage of filings that alleged misrepresentations in financial documents and false forward-looking statements. The percentage of filings alleging misrepresentations in financial documents increased from 78 percent in 2004 to 89 percent in 2005. Similarly, the percentage of filings alleging false forward-looking statements increased from 67 percent in 2004 to 82 percent in 2005. This trend suggests that the litigation market is now even more focused on the validity of financial results and forecasts presented in financial documents, such as SEC filings and press releases.

Source:

Securities Class Action Case Filings 2005: A Year In Review (Cornerstone Research)

Lawyers such as Grant also believe that accounting firms have experienced “fundamental shifts in behavior” after paying out huge sums in fines and seeing a former major player—Arthur Andersen—shut down altogether.

At the same time, lawyers are quick to note that commentators have long believed that new, tougher laws will curb wrongdoing—the Securities Act of 1933 being one of them, and look at the lawsuits filed since then. “It ebbs and flows like any other cycle,” Robbins says.

In fact, according to the Stanford study, while the total number of lawsuits last year fell, the percentage alleging false financial reporting or forward-looking statements actually increased—from 78 percent of all class-action suits in 2004 to 89 percent in 2005 for misleading financial documents, and from 67 percent to 82 percent for bogus forward-looking statements.

“This trend suggests that the litigation market is now even more focused on the validity of financial results and forecasts presented in financial documents, such as SEC filings and press releases,” the report says.

To Fujimoto, “That is an indication that the plaintiff counsel recognizes those are the cases that have traction and can be settled, and they are chasing.”

And once the market turns more volatile and experiences big declines again, experts expect yet another spike in the number of class-actions filed. Says Grant: “The only law that needs to be repealed is the law of human nature. Otherwise, greed will always bubble up. You’ll always have people with access to a lot of money who are greedy with their hand in the till, and other people willing to help.”