This content is from: Home

GOVERNANCE - Class Inaction

Five years after Sarbanes-Oxley, public-company shareholders are far less litigious than they used to be.

GOVERNANCE ISSUES and investor activism may be watchwords of the day, but in a counterintuitive development, lawsuits brought by shareholders against public companies appear to be in decline. According to a joint study by Stanford Law School and Cornerstone Research, there were 59 such suits filed during the first half of 2007, down slightly from an average of 61 during each six-month period since July 2005. These levels represent a dramatic reduction from the average rate of 101 class-action complaints lodged every six months from July 1996 through June 2005.

Why the downturn? Perhaps the biggest reason is the wave of regulation and enforcement that followed the fraud-fueled collapses of Enron Corp., WorldCom and a host of other big companies. In 2002, Congress passed the Sarbanes-Oxley Act, requiring executives to certify the accuracy of financial statements, among other measures. The Securities and Exchange Commission and U.S. stock exchanges also passed rules forcing companies to hire more independent directors and otherwise improve their governance. And federal prosecutors have charged a host of corporate executives and directors with securities-law violations in connection with the accounting scandals of the early 2000s. All that intervention seems to be having both a deterrent and a remedial effect, legal experts say.

"There are probably fewer financial and accounting irregularities," says John Coffee, Adolf A. Berle Professor of Law at Columbia Law School. "Managements have been deterred, and accountants are more rigorous."

Several recent court decisions may have contributed to the decline in class-action lawsuits as well. A 2005 U.S. Supreme Court ruling, in the case of Dura Pharmaceuticals v. Broudo, set a new standard for securities fraud claimants, requiring proof that a company's "misrepresentation (or other fraudulent conduct) proximately caused the plaintiff's economic loss." Previously, lower courts had held that shareholders needed to prove only that a stock's price was inflated at the time of purchase because of the company's misrepresentation. The high court's 2006 decision in Merrill Lynch, Pierce, Fenner & Smith v. Dabit has also been influential, securities lawyers say. In the ruling the court said that shareholders who simply chose to hold a security -- but did not buy or sell it as a result of a fraudulent statement -- could not bring class-action lawsuits in state court to get around the law prohibiting the filing of suits on these grounds in federal courts.

Of course, the stock market's bull run from 2003 until earlier this year could also be a big reason why litigation ebbed. Rising markets generate fewer losses that investors might try to recover in court. They can also help companies obscure questionable accounting practices or developing problems that become crises later.

"A strong market and business cycle can allow corporations to hide things," says Stuart Grant, a partner at law firm Grant & Eisenhofer.

Consequently, more than a few securities-litigation experts expect that the major stock indexes' recent dives presage a spike in class- action lawsuits.

"Fraud always finds a way to bounce back," says Robert Schwinger, a partner with Chadbourne & Parke, whose practice includes class-action, shareholder and other corporate-governance-related litigation. "When conditions change and there is a collapse in the market, we will see a rush of filings. Only when things start to crumble do people run around looking for other people to blame and sue."

Still, some believe that even if the pace of litigation tracks the business cycle, Sarbanes-Oxley and other postbubble reforms will have a lasting effect, so that there won't be a proliferation of new legal actions.

"Even if volatility is up and the market is down, we won't see a huge increase that will bring us back to where it was," insists Stanford Law School professor Joseph Grundfest, director of the Securities Class Action Clearinghouse, co-director of the Rock Center on Corporate Governance and a former SEC commissioner. "Executives today know that if they commit fraud, the probability of being caught is higher and the penalties will be larger, so the incentive is to commit less fraud."