Circular Lawsuits: unequal consequences

December 9, 2008

 

Chidem Kurdas

 

As investors’ portfolios go down, securities lawsuits go up. New filings increased by almost 60% in the first half of this year from the corresponding period in 2007. Given the financial and economic crisis, litigation will continue to grow. Who benefits and who  loses? 

 

There is a growing body of research on what has come to be known as the circularity problem. Anjan Thakor from the Olin School of Business at Washington University in St. Louis talked about this at a conference last week. Court-awarded damages (or settlement payments) to shareholders for securities fraud committed by company executives are mostly paid by the current shareholders.

 

Executives responsible for fraud contribute less than 1% of the typical settlement. Insurance companies are the other payer.

 

Hence the circularity: from shareholders to shareholders. But it’s not a zero-sum game for shareholders, of course, since a large chunk of the money changing hands goes to lawyers’ fees and other costs. Mr. Thakor estimated that class actions destroyed about $25 billion in shareholder value from 1995 to 2005. Click for report 

 

Moreover, small investors benefit the least from class action payouts. Diversified large institutional investors tend to break even on stocks where there is securities fraud because they sell at the higher price as well as the lower price. In lawsuits, big investors are over-compensated. Little investors should worry about ending up on the short end of the current crop of cases simply by holding a stock—we will be the unfortunate payers for misdeeds committed by others!

 

Mr. Thakor  pointed out that the need to deter securities fraud is a separate issue. Making one group of shareholders pay for another group of shareholders is not an efficient deterrent to fraud, he said. Forcing executives to return their pay can be a deterrent. 

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