• Securities Class Actions - Inherently Inferior?
  • April 22, 2010 | Author: Andrew J. Trask
  • Law Firm: McGuireWoods LLP - McLean Office
  • Securities class actions have often drawn criticisms from both defense counsel and their ideological allies. One of the more interesting criticisms has been that securities class actions may be nothing more than shell games moving money around in such a way that the only parties to benefit are the lawyers. The theory goes like this: when a plaintiff files a securities class action, she seeks compensation for a drop in the value of her shares. The firm, faced with a bet-the-company lawsuit, settles (with a payout to the plaintiffs’ lawyers). The settlement, on a prorated basis, goes to the plaintiff. And then the value of her stock in the company drops because the company has paid her a settlement and her (and its) attorneys a large fee.
    It’s a tidy story, presenting a logic that’s difficult to argue against. But is it true? Law professors Lynn Bai, James Cox, and Randall Thomas set out to test this story. Their study, “Lying and Getting Caught: An Empirical Study of the Effect of Securities Class Action Settlements on Targeted Firms” reached a number of conclusions, two of which are important to this discussion.

    • Defendant firms tend to perform worse than their counterparts after they’re sued. Or, as the authors put it, their regression analysis “confirm[s] the deterioration in sample defendants’ operational efficiency in the early years following the commencement of the lawsuit. For the post-settlement periods, defendant firms with high settlement amounts had a higher probability of under-performing their peer groups than companies facing lower settlement amounts.”
    • Class-action settlements often come out of a firm’s operating capital. “These numbers are consistent with the theory that insurance provided less than a full coverage of the settlement amounts and the discrepancy was paid out of the defendants’ current assets. The settlement payment exacerbated liquidity constraints on the part of the defendants, making them more vulnerable to liquidity crunches and prone to bankruptcy.”

    In this case, the bottom line for defendants is that securities class actions affect the bottom line of defendants. One hardly needs an academic study to prove that. But this is one of the first studies to outline the ways in which a securities class action can directly affect the financial health of a firm. Ironically, the securities class action winds up sapping the very assets that a firm needs to stay healthy, and provide an adequate return on investment for the same shareholders the lawsuit is supposed to protect. From a strictly doctrinal standpoint, this study suggests that a securities class action may not be superior to other methods of resolving any controversy arising out of a stock drop. It’s an argument that defense counsel will surely pursue further.