Shareholder Lawsuits

The general utility of shareholder lawsuits has confused me for quite some time.  Way back in the blogging stone age of 2006 I wrote a guest post at Overlawyered that said in part:

But from a philosophical standpoint, shareholder suits have never made much sense to me. While I can understand the shareholders of the company suing a minority shareholder who might be enriching themselves disproportionately (e.g. Rigas family at Adelphia), suits by shareholders against the company they own seem… crazy.

Any successful verdict for shareholders against the company would effectively come out of the pockets of the company’s owners who are.. the shareholders. So in effect, shareholders are suing themselves, and, win or lose, they as a group end up with less than if the suit had never been started, since a good chunk of the payout goes to the lawyers. The only way these suits make financial sense (except to the lawyers, like Bill Lerach) is if only a small subset of the shareholders participate, and then these are just vehicles for transferring money from half the shareholders to the other half, or in other words from one wronged party that does not engage in litigation to another wronged party who is aggressively litigious. Is there really justice here?

OK, you could argue that many of these shareholders are not suing themselves, because they are past shareholders that dumped their stock at a loss. But given these facts, these suits are even less fair. If these suits are made by past shareholders who held stock (ie, were the owners) at the time certain wrongs were committed, they are in fact paid by current and future shareholders who may well have not even owned the company at the time of the abuses, and who may in fact be participating in cleaning the company up. So these litigants are in effect making the argument that because the company was run unethically when they owned it, they are going to sue the people who bought it from them and cleaned it up? Shouldn’t the payment be the other way around, with past owners paying current owners for the mess they left?

So I found this decision in a case at Sears refreshing:

A federal appeals court on Wednesday put the kibosh on a shareholder antitrust suit against the board members of Sears Holding Corp, finding that the suit only served to enrich the plaintiffs' lawyers.

The ruling from the Chicago-based U.S. Court of Appeals for the 7th Circuit marks the latest victory for Ted Frank, of the Center for Class Action Fairness, who argued that the suit was an abuse of the legal system and conferred no benefit on Sears shareholders at large. The 7th Circuit agreed.

"The only goal of this suit appears to be fees for the plaintiffs' lawyers," Judge Frank Easterbrook wrote for a unanimous three-judge panel.

Several law firms, including Vianale & Vianale, filed the proposed class action on behalf of two named investors in 2009. The derivative suit accused two Sears directors of holding positions on the boards of several competing companies, in violation of federal antitrust law.

Given the high cost of litigating an antitrust suit, Sears reached a settlement with the investor plaintiffs, agreeing to get rid of one of the directors and pay $925,000 to the investors' attorneys.

Frank, who specializes in challenging class action settlements, argued that the resolution was a raw deal for Sears shareholders, costing them legal fees and a director they had recently re-elected. The deal also would not prevent someone else from filing a copycat suit, given that one of the two targeted directors would remain on the Sears board. What's more, the problem of interlocking boards is usually resolved when the Department of Justice or the Federal Trade Commission asks a company to fix the violation.

Frank, himself a Sears shareholder, asked to intervene in the case to block the settlement, but the Illinois district court refused, finding that the plaintiff investors adequately represented the interests of Frank and the other shareholders.

On appeal, the 7th Circuit panel reached the opposite conclusion, finding the interests to be "entirely incompatible." The panel sent the case back to the district court, with instructions to allow Frank to intervene and to rule in favor of the Sears defendants.

"The suit serves no goal other than to move money from the corporate treasury to the attorneys' coffers, while depriving Sears of directors whom its investors freely elected," Easterbrook wrote.

  • Ted Rado

    The problem is that many boards of directors are in the CEO's pocket, and are simply rubber stamps. There is no real oversight. A board of directors that is free to comment on the CEO's decisions is useful. Many heads reviewing a proposed course of action much increases the liklihood that a huge blunder will be avoided. In many corporations, if a strong-wlled CEO is backed by a rubber stamp board, there is likely to be a catastrophe. Stockholder lawsuits are a good way to bring this situation to light. Chesapeake Energy, anyone?

  • Mike H

    In my head, I always thought of shareholder lawsuits as shareholders suing to reverse a decision by management intended to benefit management at the expense of the company. That at least makes sense to me.

  • http://islandturtle.blogspot.com Corky Boyd

    While it is obvious that suing the company for a billion dollars will reducee the value of the company by a like amount, lawyers have figured out how to game the system. They sue on behalf of a select group of shareholders who have been "wronged." For instance, if the company finds a major client will be cancelling a contract and the company delays the announcemant while it tries and fails to renegotioate the contract, they can expect to be sued on behalf of shareholders who purchased stock during the time of first knowledge to the time of the announcement.

    These are frivolous suits that usually never go to trial. They are settled for paltry amounts, benefitting primarily the lawyers who brought the cases.

  • Patrick

    How often are lawsuit decisions made like this? Is this a new practice?

  • W. C. Taqiyya

    It is truly shocking that any court would make such a ruling. It is even more shocking that this court actually said it's reason was that the lawsuit benefited only the attorneys. In my admittedly vast experience, courts and judges exist to serve the interests of the bar association. You know, to fill the wallets of lawyers. All other considerations are secondary, at best. The fancy wording is just chaff for the uninitiated. This post is really amazing.

  • Joyce

    This judge should deserves a Congressional Medal of Honor. Well done sir!

  • me

    Well, like so many things, it's a question of timing. If I own shared in CulpableCorp (CC) on 1/1/2013, and the price takes a hit, so that I sell for $5 instead of $10, then technically speaking, I can profit from a lawsuit against CC for $5 in damages while the negative effect is borne by current shareholders.

  • Craig

    Don't forget the activists who buy one share so they can wreak havoc.

  • http://Jamesbbkk.com Jamesbbkk

    Exactly right. Most of these suits deal with allegations of non-disclosure usually on a heavy advocacy parsing of extensive disclosure documents. Inevitably it seems after any merger there is the subsequent suit settled by management and class representatives for several hundred thousand to a couple million dollars (for billion dollar plus transactions the value of or damage caused by non-disclosure based on such settlement amounts is dubious). Shareholders are instructed to file proofs of claim showing all relevant transaction history with supporting trade confirmations - even though brokerage records should disclose this information - for at most a penny or two per share. So small shareholders don't take the trouble to file shrinking the pool of claimants. Litigants further rewarded over non-litigants. Also, don't forget the brilliance of the SEC fining companies for poor disclosure or stock market fraud, thus taking money from the shareholders entirely, in a pose of protecting them. There was one case where the SEC was going to distribute penalties to shareholders (I think it was BofA / Merrill), but again too much paperwork to be worth the while for most folks relative to return. Stock markets should have prison for theft by fraud by management or selling shareholders, but not mistakes, in initial offerings, and caveat emptor (and its complement for sellers, caveat vendor?) for all secondary market trades. You sell during even a flash crash, take your medicine. You buy on poor disclosure, take your medicine. Folks need to stop pretending the government and class action lawyers of all people can look after their financial interests. History shows repeated failure.

  • mark2

    @me

    Unfortunately - having been forced into one or two of these myself. What usually happens is that the company settles out of court, because they don't want to go through the nuicance and publicity of a trial. The Lawyers involved take 80 -90% of the money for various fees, for legal sevices, notifications, etc, and the shareholder who sold at a loss, gets 10% on the dollar of their loss if lucky. Sometimes they get a coupon for 20% off the companies product.

  • John David Galt

    Don't you think the right answer to this would be an automatic rule that pierces corporate veils when an officer or director misuses his position, so that he personally can pay the price instead of the shareholders paying themselves?