Commentary: Do Shareholder Class Actions Make Sense?

When New York Federal District Court Judge Jed S. Rakoff rejected a proposed $33 million securities fraud settlement between the Securities & Exchange Commission and Bank of America (BAC) on Sept. 14, he pointed out that the money would come out of the pockets of BofA investors—meaning that "shareholders who were the victims of the bank's alleged misconduct [would] now pay the penalty for that misconduct."

The settlement agreement aimed to resolve allegations that, during its acquisition of Merrill Lynch at the end of last year, BofA concealed information from investors about Merrill's plan to pay up to $5.8 billion in bonuses to its executives. Rakoff said the SEC didn't adequately explain why it had not pursued charges directly against the bank executives or lawyers allegedly responsible for issuing "false and misleading" proxy statements and instead targeted the corporation. In his order nixing the deal, he called it "unfair," "unreasonable," and "inadequate."

Rakoff's ruling prompts a question that seems to garner little attention outside a small circle of academics: Why do we tolerate the same perverse approach and empty outcomes in the resolution of private shareholder class actions? These lawsuits, typically filed by institutional investors, are independent of any government action and seek to recoup shareholder losses allegedly caused by a company providing false or incomplete information to the market. The value of settlements in such cases can dwarf those obtained by federal and state regulators, and there is widespread agreement among legal scholars that these class actions make little economic sense and are anemic deterrents to fraud.

Yet, while exacting little if any price from the executives and corporate advisers who led investors astray, this litigation costs corporations (read: shareholders) dearly. Even excluding the mega-cases of Enron, WorldCom, and Tyco International (TYC), businesses paid out $21 billion to settle investor claims in the five-year period from 2004 through 2008, according to Cornerstone Research. (Including those cases, the amount was $42 billion.) On top of that companies can pay their defense lawyers upwards of 20% of what they shell out in settlements.

On the same day Judge Rakoff issued his ruling, President Barack Obama made a speech on Wall Street, stressing his Administration's plan to enact "the most ambitious overhaul of the financial system since the Great Depression." While proponents of shareholder class actions have long held them up as a vital supplement to government enforcement—a way to add thousands of cops to the regulatory beat and compensate the wronged—a close look at private suits filed in the BofA-Merrill deal reveals the illogic of these claims.

SHAREHOLDER VS. SHAREHOLDERJust weeks after BofA closed its acquisition of Merrill on Jan. 1, investors saw the value of their shares plummet when it was revealed that Merrill's losses for 2008 were $27 billion, far higher than anticipated. The shareholder claims almost all involve "aftermarket" investors, who bought and sold from one another in the secondary market, not directly from the corporation through a stock offering. So BofA investors who sold for a loss after Merrill Lynch's financial plight became known are now seeking payment from BofA investors who didn't sell or who acquired their shares after the price drop. Total losses haven't been specified, but collectively investors are seeking to recoup billions.

The age-old purpose of fraud claims is to force a wrongdoer to cough up ill-gotten gains to the person deceived. Shareholder lawsuits do no such thing. "An aftermarket fraud causes no transfer of wealth from an innocent victim to a guilty perpetrator of the fraud," noted Stanford University law professor and former SEC Commissioner Joseph A. Grundfest in a filing in an unrelated proceeding. "Instead, it causes a wealth transfer among equally innocent third parties." Other critics have referred to this as "circularity" or "pocket shifting."

On June 30, Judge Rakoff's courthouse colleague, U.S. District Court Judge Denny Chin, designated a group of five pension funds to lead the proposed class action in the case against BofA. While the SEC seeks to mete out discipline—through civil, not criminal proceedings—the case spearheaded by the pension funds seeks compensation for investor losses. As if having one group of investors pay another isn't odd enough, the situation gets even more twisted. Securities filings show that a number of funds sold a portion of their BofA shares but continued to hold large positions in the bank after the mid-January stock drop. Some, like the Teacher Retirement System of Texas (TRS), were also big holders of Merrill shares, which as of Jan. 1 were converted into BofA stock. The result: A portion of any compensation they get will come from themselves.

There's another reason to question the idea of allowing investors to collect for securities fraud losses. Even though neither side in an aftermarket transaction participates in the fraud that inflates the price of a stock, the seller still benefits, while the buyer loses. A number of scholars contend that investors who are diversified in the market (as is common) will on average be the beneficiaries of fraud as often as victims. This means that, over time, their gains and losses will net out at close to zero. It also means that any recovery in a lawsuit is likely to be an undeserved windfall. TRS, for example, wants money back for its losses allegedly caused by BofA's fraud. Yet last year, TRS sold shares in SunTrust Banks during a time when another lawsuit alleges SunTrust's share price was artificially high because of fraud. (BofA and SunTrust say the fraud allegations are without merit.)

The contradictions and costs of shareholder class actions as a means to compensate investors for fraud-related losses might be deemed acceptable if they effectively served another key social goal—deterring fraud in the first place. It's hard to find anybody (outside the plaintiffs' bar) who thinks they do.

Why? Because the costs of litigation, including settlements and attorneys' fees, are generally paid for by the corporation's shareholders, not the executives who committed the fraud. And settlements of investor class actions are so routine, either because they are costly to fight or because a company doesn't want to risk a potentially massive jury verdict, that they carry little or no opprobrium. After all, in settlements of shareholder suits—just as with the SEC's proposed deal with BofA—the defendants do not admit any wrongdoing. No cost to the perpetrators, no shame—where's the deterrence?

Any comprehensive reform of the financial system should include a fundamental reconception of shareholder lawsuits. Rather than compensating secondary-market investors, their aim should be to deter fraudulent conduct. That means directors and officers need to be far more than just titular defendants—they need to have skin in the game.

Business Exchange: Read, save, and add content on BW's new Web 2.0 topic networkLose Some, Win SomeA number of legal scholars have noted that, over time, diversified investors will gain from securities fraud as often as they lose. A 2005 report by Navigant Consulting concludes that large institutional investors who recover their losses through litigation end up being overcompensated because they are not required to give up their gains.To view the report, go to

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