Shareholders Lose Out in Class Action Securities Settlements, Says University Study

August 9, 2006

Since 1995, there have been 755 separate cases of class action securities litigation on allegations of companies inflating their stock prices due to fraud or untimely disclosure. Settlements from these cases totaled about $25.4 billion. On the surface, it appears that wronged shareholders have received just retribution for the losses incurred from purchasing stocks at inflated prices. But research from a professor at the Olin School of Business at Washington University in St. Louis shows that individual shareholders aren’t receiving much benefit at all – in fact, if anything they’re losing out.

“The majority of participants in securities class action suits are institutional investors who trade more than $100 million a year. They don’t have to pay for any gains they made from selling the inflated stocks, and once they’re compensated for their losses they actually come out ahead,” said Anjan Thakor, PhD., finance professor at the Olin School of Business.

“Institutional investors are trading such a large volume. The net trading loss they suffer from buying inflated stocks is only 20 percent of their gross losses. Of the more than 2,300 firms we studied, 40 percent were shown to have realized a net benefit from the settlement proceeds.”

The only way institutional investors might lose from buying inflated shares of stock is if they buy newly issued securities.

Thakor said that the Private Securities Litigation Reform Act of 1995 causes an asymmetry in how much benefit investors receive when companies actu fraudulently.

“What’s worse is that the system is set up so that one group of shareholders ends up suing another group of shareholders. If I’m a shareholder who bought stock before the period where stocks were inflated, I can’t take part in the litigation, yet I will essentially be paying the settlement to those investors who did buy inflated shares,” Thakor said.

“It’s a process of taking money from one group of shareholders in the company and giving it to another for some wrongdoing by the company. Well, send the managers to jail. Fine them. Do whatever you want to do with them. But why should I be paying a fellow shareholder when I’m not responsible for the problem?”

Thakor said that the injustice of the system is made worse because the actual transfer of the payment is not a neutral process either. Huge resources are used up paying the lawyers and accountants who handled the litigation. After those expenses are paid, investors end up with maybe three cents on the dollar.

“The settlement doesn’t help the shareholders who paid the fine since they’re paying out of their own pocket. It doesn’t really help the shareholders who sued company, who barely recover their losses. So who made the money? Large institutional investors handling more than $100 million in assets, the lawyers and the accountants,” Thakor said.

The inequities that Thakor discovered are part of an analysis he conducted for the U. S. Chamber Institute for Legal Reform. He said his findings are disheartening since the Private Securities Litigation Reform Act of 1995 was an attempt to promote transparency in corporate activities and prevent fraud.

In Thakor’s opinion, it’s time to re-examine the act, incorporating ways to appropriately punish those who committed the wrongdoing. The focus ought to be on getting managers to comply since they’re the ones making the decisions so we can have a transparent financial market.

” I don’t think you should get there by having system by which the only people who benefit are the lawyers, accountants and large institutional investors. The system ought to impose punishment on the people who committed the crime — that ought to be the managers, not the shareholders.”

Source: Washington University in St. Louis

Topics Lawsuits Education Universities

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