Who Really Wins in Shareholder Lawsuits?

It is commonplace for shareholder lawsuits to arise against corporations when they are required by the SEC to restate earnings for prior periods. When earnings restatement causes a drop in earnings previously stated, the value of the stock sold during the restated period also drops (not to mention its current selling price). Shareholders then attempt to recover their losses through derivative or class action suits. Traditionally, the law has provided for these types of suits as deterrents to acts of negligence and/or fraud by corporate officers and directors and, of course, to provide a means by which shareholders can receive compensation for injurious acts committed by the same. However, in reality, a shareholder cannot expect to recoup, dollar for dollar, the difference between the price paid per share and the restated value per share. In fact, after attorneys’ fees, shareholders should consider themselves lucky to receive as little as $0.15 per share, if anything. That is according to Bhagat and Romano in Empirical Studies of Corporate Law (2004), who also state, “[derivative] suits typically result in no or very low monetary rewards” for shareholders.

The study further points out that a large portion (if not most) of settlement payments or awards in these suits goes to the plaintiffs’ attorneys. In addition, many times these payments (or portions thereof) are made by the defendants’ liability insurers, whose premiums rise as the frequency, cost, and risk of litigation increases. Then, once the legal dust has settled, in many circumstances, corporations are allowed to expense these payments, thereby creating huge tax deductions (as much as $0.40 per dollar paid in settlement) and, in some cases, even tax credits or refunds for the prior years in which earnings were restated. This adds up to huge sums of money that could more rightfully be used to help decrease the federal deficit (See Companies Settling Suits Pay Lower Taxes and Companies That Inflated Earnings Now Seek Tax Refunds.) Of course, even with the tax breaks, in the face of the double-whammy of lawsuits by both the SEC and shareholders, corporations still lose in a big way in terms of investor confidence and stock price. But it seems that shareholders gain virtually nothing to speak of, as well, from these lawsuits which sometimes further embed an indelible bad image of the corporation in the minds of potential investors. An article states that Time Warner’s stock has yet to recover from at least a 75% price reduction resulting from shareholder lawsuits arising from the company’s merger with AOL back in 2000.

With the combination of stricter regulation by the SEC, requirements set forth by the Sarbanes-Oxley Act, and the oversight of the PCAOB all potentially resulting in more restatements, it will be interesting to see whether, and at what point, legislation is enacted to curtail frivolous derivative lawsuits that only serve to richen attorneys and insurers. (Or, how long will it take for shareholders to realize the same?)

More to come on the effects of restatements.