A recent article in BusinessWeek raised an interesting argument about the logic of shareholder class action suits. After the Bank of America settlement agreement was rejected by New York Federal District Court Judge Rakoff, an interesting perspective in opposition of shareholder class action suits emerged. In the settlement between BofA and the SEC, Rakoff criticized the SEC for not providing adequate justification for not filing suit against BofA executives who were allegedly responsible for the false and misleading information, but instead pursuing a civil action against the corporation. Rakoff pointed out that the shareholders, who were the victims of the misconduct, would also be the ones ultimately responsible for paying the settlement.
Private investor suits are usually brought by large institutional investors and are separate from any government actions brought against a company. These suits garner settlements much larger than those typically seen in government actions. Shareholder class action suits against corporations have generally been thought to provide additional corporate policing to deter fraud and as a way for shareholders to hold corporations accountable for their misdeeds. However, Rakoff and other proponents argue the opposite: shareholders pay the price for the corporate misdeeds, while executives and other wrongdoers escape the costs.
They claim, rather, that class action suits pit shareholders against each other. Shareholders who acquire a company’s stock generally do so in an aftermarket transaction, not directly from the stock offering of a company. This effectively means investors who sold their stock at a loss are bringing suit against the shareholders who did not sell their shares or who acquired shares after the price drop. Former SEC Commissioner and Stanford University law professor, Joseph A Gundfest, notes that these aftermarket fraud cases end up causing “a wealth transfer among equally innocent third parties.” According to Judge Rakoff, this is precisely the setup in the BofA suit and is also the reason why he rejected the settlement.
Therefore, the shareholders who still hold the stock end up paying the settlement and attorneys’ fees. This “circularity” of funds circumvents those who actually perpetrated the fraud and places the cost with the shareholders still holding the stocks. This is a direct contradiction to the original purpose of compensating investors for their losses due to fraudulent behavior and does not deter fraud. As such, advocates of this view believe that financial system reforms should include new rules about shareholder lawsuits that target corporate executives rather than aftermarket investors. However, this is a view that remains largely in the academic arena, not the public. Currently, the new proposals in the legislature do not include any such reforms.
The full article can be found here.