Shareholders lose out in class action securities settlements, study says

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 in these cases have totaled about $25.4 billion.

On the surface, it appears that wronged shareholders have received just retribution for losses incurred from purchasing stocks at inflated prices. But a professor at the Olin School of Business at Washington University in St. Louis says individual shareholders aren’t receiving much benefit at all — in fact, 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,” Thakor said.

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 act fraudulently.

Groups suits
“What’s worse is that the system is set up so that one group of shareholders ends up suing another group of shareholders,” Thakor contends.

“If I’m a shareholder who bought stock before the period when 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 that the injustice of the system is made worse because the transfer of the payment is not a neutral process either. Huge resources are used to pay the lawyers and accountants who handled the litigation. After those expenses are paid, investors end up with maybe 3 cents on the dollar.

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 because the Private Securities Litigation Reform Act of 1995 was an attempt to promote transparency in corporations and prevent fraud.

In Thakor’s opinion, it is time to re-examine the act, incorporating ways to punish those who committed the wrongdoing. The focus ought to be on getting managers to comply because they’re the ones making the decisions that prevents a transparent financial market, he said.

“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,” he said. “The system ought to impose punishment on the people who committed the crime — that ought to be the managers, not the shareholders.”