Not quite, says a study in the Financial Analysts Journal by Rob Bauer and Robin Braun. If a suit is for something other than illegal insider trading, the long-term effects of litigation for shareholders are not good, despite the fact that many cases involve injunctive relief with supposed corporate governance improvements. I've long theorized that most injunctive relief in class action settlements is for the benefit of attorneys to claim that they accomplished something when they are unable to obtain pecuniary relief; the fig-leaf of trivial changes allows the attorneys to claim fees.
Ted's exactly right, of course. But there's an even broader problem with securities litigation, which I documented in Corporate Governance and U.S. Capital Market Competitiveness:
An effective anti-fraud regime has obvious benefits. It serves to compensate defrauded investors. It deters fraud. It provides a bond making issuer disclosures more credible and thereby lowers the cost of capital. The question remains, however, whether the current U.S. anti-fraud regime imposes costs that may outweigh or, at least, reduce these benefits.
An affirmative answer to that question is suggested by a survey of global financial services executives, which found that the litigious nature of U.S. society and capital markets has a negative impact on the competitiveness of those markets.[1] The key problem appears to be the prevalence of private party securities fraud class actions, which do not exist in most other major capital market jurisdictions.
Between 1997 and 2005 there was a steady increase in both the number of securities class action filings and the average settlement value of those suits.[2] The total amount paid in securities class actions peaked in 2006 at over $10 billion, even excluding the massive $7 billion Enron settlement.[3] The vast majority of such settlement payments historically have been made either by issuers or their insurers, rather than by individual defendants.[4] As a result, the vast bulk of securities settlement payments come out of the corporate treasury, either directly or indirectly in the form of higher insurance premia. In either case, settlement payments reduce the value of the residual claim on the corporation's assets and earnings. In effect, the company’s current shareholders pay the settlement, not the directors or officers who actually committed the alleged wrongdoing.
The effect of securities class actions thus is a wealth transfer from the company’s current shareholders to those who held the shares at the time of the alleged wrongdoing. In the case of a diversified investor, such transfers are likely to be a net wash, as the investor is unlikely to be systematically on one side of the transfer rather than the other. Because there are substantial transaction costs associated with such transfers, moreover, the diversified investor is likely to experience an overall loss of wealth as a result of the private securities class actions. Legal fees to plaintiff counsel typically take 25-35% of any monetary class action settlement, for example, and the corporation’s defense costs are likely comparable in magnitude.[5]
The circularity inherent in the securities class action process reduces the effectiveness of private anti-fraud litigation as both a deterrent and means of compensation. As to deterrence, because it is the company and not the individual wrongdoers that pays in the vast majority of cases, the system fails to directly punish those individuals. As to compensation, the transaction costs associated with securities litigation ensure that investors are unlikely to recover the full amount of their claims. Indeed, there is evidence that investors recover only two to three percent of their economic losses through class actions.
[1] Bloomberg Schumer Report, supra note 1, at 73.
[2] See Paulson Committee Report, supra note 2, at 75. A mid-decade dip in filings was probably caused by the lack of volatility in U.S. stock markets during the period and the fading of the substantial litigation generated by the bursting of the dot-com bubble. Bloomberg-Schumer Report, supra note 1, at 74.
[3] Statement of the Financial Economists Roundtable on the International Competitiveness of U.S. Capital Markets, 19 J. Applied Corp. Fin. 54, 55 (2007) [hereinafter FER].
[4] Id.
[5] Id.
