Commentary September 17, 2009, 5:00PM EST

Commentary: Do Shareholder Class Actions Make Sense?

Not when they extract payments from innocent shareholders and let fraudsters off the hook

Browse Issues

Story Tools

When New York Federal District Court Judge Jed S. Rakoff rejected a proposed $33 million securities fraud settlement between the Securities & Exchange Commission and Bank of America (BAC) on Sept. 14, he pointed out that the money would come out of the pockets of BofA investors—meaning that "shareholders who were the victims of the bank's alleged misconduct [would] now pay the penalty for that misconduct."

The settlement agreement aimed to resolve allegations that, during its acquisition of Merrill Lynch at the end of last year, BofA concealed information from investors about Merrill's plan to pay up to $5.8 billion in bonuses to its executives. Rakoff said the SEC didn't adequately explain why it had not pursued charges directly against the bank executives or lawyers allegedly responsible for issuing "false and misleading" proxy statements and instead targeted the corporation. In his order nixing the deal, he called it "unfair," "unreasonable," and "inadequate."

Rakoff's ruling prompts a question that seems to garner little attention outside a small circle of academics: Why do we tolerate the same perverse approach and empty outcomes in the resolution of private shareholder class actions? These lawsuits, typically filed by institutional investors, are independent of any government action and seek to recoup shareholder losses allegedly caused by a company providing false or incomplete information to the market. The value of settlements in such cases can dwarf those obtained by federal and state regulators, and there is widespread agreement among legal scholars that these class actions make little economic sense and are anemic deterrents to fraud.

Yet, while exacting little if any price from the executives and corporate advisers who led investors astray, this litigation costs corporations (read: shareholders) dearly. Even excluding the mega-cases of Enron, WorldCom, and Tyco International (TYC), businesses paid out $21 billion to settle investor claims in the five-year period from 2004 through 2008, according to Cornerstone Research. (Including those cases, the amount was $42 billion.) On top of that companies can pay their defense lawyers upwards of 20% of what they shell out in settlements.

On the same day Judge Rakoff issued his ruling, President Barack Obama made a speech on Wall Street, stressing his Administration's plan to enact "the most ambitious overhaul of the financial system since the Great Depression." While proponents of shareholder class actions have long held them up as a vital supplement to government enforcement—a way to add thousands of cops to the regulatory beat and compensate the wronged—a close look at private suits filed in the BofA-Merrill deal reveals the illogic of these claims.

SHAREHOLDER VS. SHAREHOLDER

Just weeks after BofA closed its acquisition of Merrill on Jan. 1, investors saw the value of their shares plummet when it was revealed that Merrill's losses for 2008 were $27 billion, far higher than anticipated. The shareholder claims almost all involve "aftermarket" investors, who bought and sold from one another in the secondary market, not directly from the corporation through a stock offering. So BofA investors who sold for a loss after Merrill Lynch's financial plight became known are now seeking payment from BofA investors who didn't sell or who acquired their shares after the price drop. Total losses haven't been specified, but collectively investors are seeking to recoup billions.

The age-old purpose of fraud claims is to force a wrongdoer to cough up ill-gotten gains to the person deceived. Shareholder lawsuits do no such thing. "An aftermarket fraud causes no transfer of wealth from an innocent victim to a guilty perpetrator of the fraud," noted Stanford University law professor and former SEC Commissioner Joseph A. Grundfest in a filing in an unrelated proceeding. "