Shareholder Lawsuit's Bear's Den
by Bill Barker

I’m not entirely sure what we’re dueling about here. Both shareholders and companies suffer under the current state of affairs in the securities class action field, and basically lawyers are the only ones who profit under the current system. Is Louis arguing that shareholders, on the whole, actually benefit from these strike suits? If so, sit right back and you’ll hear a tale.

Securities class action suits are a potentially powerful tool to ensure that companies and management accurately convey to the marketplace the information necessary for investors to properly value stocks. There are countless examples of the proper and effective use of these suits. Unfortunately, because of the overwhelming and continuing misuse of the system, the only thing really evident when one of these suits is filed is that a stock price has plummeted and some lawyers feel that means they are entitled to a big chunk of money.

That is not my conclusion; it's Congress's. Following Congressional hearings leading up to the passage of the Private Securities Litigation Reform Act of 1995, the House and Senate Committees concluded that the securities class action suits were characterized by: 1) the routine filing of lawsuits whenever there was a significant change in a stock’s price without regard to any underlying culpability of the company; 2) the targeting of deep pockets individuals; 3) the abuse of the discovery process to impose costs so burdensome that it was simply more economical for the victimized company to settle; and 4) the manipulation by the class action lawyers of the clients they claimed they represented.

Excuse me, did somebody say clients? Class action lawyers don’t have clients -- at least not in their own minds. In an October 11, 1993, Forbes article entitled “I Have No Clients,” William Lerach of the infamous Milberg Weiss securities class action law firm was quoted saying, “I have the greatest practice of law in the world. I have no clients.”

What, after all, can you say about such a man that he hasn’t just said about himself?

In 1997 hearings on whether the 1995 law was succeeding, Senator Christopher Dodd said, “[S]ome of the stories, were they not so tragic, would be downright humorous, where you had the computer-generated complaints... just one example after another of how the system had gone awry, to put it mildly.”

One example of this long-running tragicomedy put on for our amusement and tears involves a case, In re: Pacific Securities Litigation, in which these fine, fine representatives of their clients’ interests presented a $12 million negotiated settlement to the court for approval. Not bad you might say, but the problem was the lawyers determined that they should get $8 million of the award, and the plaintiffs, well, they should get $4 million -- and be happy about it. When a lone shareholder opined that it seemed slightly unfair that the attorneys should get to keep 2/3 of the loot as a reward for negotiating a settlement that didn’t approach the amount of money that was actually lost by the shareholders in the first place, the judge informed the lawyers that he would have an independent expert examine the worth of the proposed settlement. Rather than have its work looked over by an impartial party, the lawyers beat a hasty retreat, and, without comment, immediately dropped their fee request by $4 million.

That has been the continual problem. Attorneys operate under the assumption that they have no clients, are not being watched, and can pursue settlements with the sole intent of maximizing their fees, rather than to see any wrongs righted. This myopic cupidity comes at a price, and not at all just to the defendant companies. A 1990 study published in The Stanford Law Review concluded that there was essentially no correlation between the merits of a case and the amount of a settlement. The market seemed to have established a going settlement rate of about 25% of the amount claimed as losses by the plaintiffs, with lawyers pocketing about 1/3 of that recovery, regardless of whether anything improper had been done. Shareholders who actually had real cases were not receiving any more than those who did not.

The effect of this (aside from breeding further cynicism toward the legal system) is that directly or indirectly the investing public itself pays the price through higher premiums paid by all companies on the liability insurance that covers the settlement amounts. Over the long run, all of us shareholders are the ones paying the exorbitant legal fees.

The 1995 Reform Act (passed over President Clinton’s veto) was, among other things, meant to change that by encouraging the participation in suits by large institutional investors as lead plaintiffs who could take control of the litigation away from the attorneys. It was presumed that institutional investors, particularly pension funds (because of their ultimate fiduciary duty to small shareholders), would best be able to balance the long-term interests of the company with the interests of the class in directing litigation.

As one court recently put it, “The best relief for the plaintiff class is not always the relief which would be sought by a ‘professional plaintiff’ or a plaintiff with a very small share in the defendant’s company. As discussed above, lawyers for such plaintiffs have strong incentives to seek the maximum damage award possible without regard to future company performance or share appreciation. Yet, overall return to the plaintiff class would, in some circumstances, be maximized through a less-than-maximum damage payment immediately and subsequent faster growth of company value. Though considering the long-term interests of defendant companies might in some circumstances reduce the immediate damage payments to the plaintiff class (and, consequently, the payment to plaintiffs’ lawyers), it will also improve the chances that the company will experience future growth.” 3:96-CV-1353-R CellStar Corp. Class Action Order.

Unfortunately, as you can imagine, the lawyers want no part of anybody balancing any interests, and at present, actively contest institutional leadership in the suits -- and institutions are not stepping forward as a result. Until institutional investors shoulder the responsibility Congress set out for them, both shareholders and companies are going to continue to be plagued by attorney-driven litigation -- and we are all going to continue paying the price.

Next: The Bull Responds