Shareholder Lawsuit's Bull's Pen
by Louis Corrigan ([email protected])

Let me concede the obvious: class action shareowner lawsuits are, at best, a poor solution to a problem. While some plaintiffs' attorneys (particularly the dominant Milberg Weiss Bershad Hynes & Lerach) make off with millions of dollars, defrauded shareowners of the target company get back a couple of dimes on the dollar -- at most.

Meanwhile, these lawsuits distract a company's management from running the business, push up insurance premiums, and produce costly legal bills. If capitalism is designed to serve the interests of capital, labor, and consumers, then securities lawsuits clearly involve too many lawyers wasting too much time and money to be seen as anything but a necessary evil.

And that's "at best." At worst, these class action suits do seem to simply mushroom in response to any major stock decline or significant earnings shortfall. Despite the tougher standards established by the 1995 Securities Litigation Reform Act, so-called frivolous strike suits can still seem all the rage. If you're a high-tech investor, you likely own shares in at least one company that's currently the target of a securities lawsuit. It's enough to make one think the plaintiffs' attorneys invented the "Asia contagion" in a lab at Stanford in order to stir up business.

Yet, shareholders that take the trouble to read a company's SEC filings and understand the firm's competitive challenges often deem disappointing results lamentable but hardly part of a fraudulent scheme. So the lawsuit notices can seem comical, as if they've been stamped from the same cookie-cutter and are designed simply to make the plaintiffs' attorneys rich through a quick settlement (assuming the suit at least survives the initial motion to dismiss).

But though there's some truth in this impression, securities lawsuits do address a serious problem: fraud.

Every year, there are at least a couple of stunning cases -- a MediaVision or a Centennial Technology -- where it's discovered that a company's officers engaged in the most blatant fraud, such as shipping products or even empty boxes to a CEO's private warehouse so these "orders" could be reported as revenues. Lest anyone forget, both companies were highfliers with significant institutional support. They weren't mere penny stocks, at least not until the end, when they collapsed after the truth came out. One would hardly want a system of legal protections that prevented shareholders from receiving some recompense from companies that engaged in such actions.

Of course, alleged fraud often melds with incompetence or arrogance. Think Oxford Health <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: OXHP)") else Response.Write("(Nasdaq: OXHP)") end if %> or Columbia/HCA <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: COL)") else Response.Write("(NYSE: COL)") end if %>. And sometimes the alleged fraud is considerably less obvious, even after the fact. It often relates to the slippery issue of disclosure, of what management knew and when, and whether they benefited from delays in telling other investors the news or from misrepresentations of that news.

There are two common legal pegs here. The first is accounting fraud owing to misrepresentations or omissions in financial statements (cited in 67% of recent cases). Often, the accounting fraud is said to have masked poor results so that the company could float an important equity or debt offering. The second peg is trading by insiders during the class period (cited in 59% of recent cases). Top executives are often alleged to have fudged the truth since they may have held lucrative options packages that would have been hurt by poor earnings results. Or more typically, they might have sold some of their own shares before the bad news got out.

Let me just make a few quick points about these more complex, disclosure-related cases. First, major U.S. companies routinely engage in selective disclosure, so there's no reason for investors to give corporate managers the benefit of the doubt. Second, companies with poor disclosure practices often have weak corporate boards, which suggests the likelihood that the all-important audit committee, which ought to catch genuine fraud, will fail to do its job.

Third, because of points one and two, there's good reason for investors to believe that fraud is possible and thus no good reason to put undue obstacles in the way of securities fraud cases. Except for the most obviously frivolous lawsuits (which judges will dismiss with prejudice), it's simply difficult to determine that fraud has not been committed before full discovery occurs. Though discovery is often seen as a fishing expedition, you don't catch fish unless they're in the pond.

Fourth, despite the "safe harbor" provision of the 1995 Securities Litigation Reform Act that protects forward-looking statements made in conjunction with proper cautionary language, some forward guidance is so reckless as to be unsupported by a company's business. That kind of garbage should continue to be open to litigation.

To take some obvious examples, Boston Chicken <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: BOST)") else Response.Write("(Nasdaq: BOST)") end if %> stated repeatedly that based on its thorough economic review, it did not need to set aside any reserves for losses on its loans to its area developers of Boston Market or Einstein Bagel <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ENBX)") else Response.Write("(Nasdaq: ENBX)") end if %> stores. When the chickens came home to roost over this ridiculous accounting judgment (and thus misleading disclosure), Boston Chicken ended up setting aside hundreds of millions of dollars in reserves for loan losses and the write down of other assets. By then, shareholders had been carved up.

Then there was the case of LaserSight <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: LASE)") else Response.Write("(Nasdaq: LASE)") end if %>, a firm that manufactures and sells laser equipment used in photorefractive keractectomy (PRK) eye surgery. Its stock plummeted in 1996 after its wildly optimistic forward guidance proved to be a complete joke.

It's important to remember that our economic system absolutely depends on a vibrant atmosphere for civil suits against corporate wrongdoers. That's because the SEC has its hands full. Excluding notable exceptions, often brought to its attention by short-sellers, the SEC just doesn't evaluate the reliability of federal filings by public companies. Moreover, the Wall Street analyst community has repeatedly shown an inability, or perhaps disinterest, in doing the kind of serious research that would uncover potential problems. For example, Oxford Health's collapse came while all the analysts remained fundamentally bullish. Boston Chicken and Einstein Bagel imploded despite a sea of positive analyst comments. In addition, while auditors sometimes find junky accounting, they also sign off on lots of garbage.

What reasonable people should want from the securities laws is for investors to have a fair chance to go after a company that's committed fraud while companies have a fair shot at fending off truly unwarranted lawsuits. The new securities reform act that recently passed the U.S. Senate 79 to 21, and seems likely to be approved by the House in July, is a hasty attempt to revamp the Reform Act of '95 before the fundamental legal issues pertaining to that Act have really been determined by the courts. But it may reconcile these twin goals by strengthening both sides in the struggle.

The high-tech companies and venture capitalists that have backed the reform bill will be happy to see plaintiffs restricted in their ability to bring cases in state courts, as they did in droves following the '95 Act, in part to aid in the discovery process for parallel federal cases. On the flip side, though, SEC Chair Arthur Levitt has secured wording that will solidify "reckless misconduct" as the standard for bringing suits, rather than the far more difficult hurdle of "intentional misconduct," which some courts had suggested should be the post-'95 standard.

That's a compromise, but one that at least rationalizes and clarifies the litigation process. And make no mistake, if you wake up one morning holding Fine Host <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: FINE)") else Response.Write("(Nasdaq: FINE)") end if %> shares after the board's audit committee finally uncovers a accounting irregularities, you'll want the securities laws to allow you ample room for satisfaction.

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