Shareholders lose when companies are sued for inflated stock prices

Class action securities litigation doesn't punish the responsible party

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 from these cases totaled about $25.4 billion. On the surface, it appears that wronged shareholders have received just retribution for the losses incurred from purchasing stocks at inflated prices. But research by a professor at the Olin School of Business at Washington University in St. Louis shows that individual shareholders aren’t receiving much benefit at all – in fact, if anything they’re losing out.

“Many participants in securities class action suits are institutional investors who trade more than $100 million a year. They typically hold diversified portfolios and are both buyers and sellers of various stocks that are the subject of litigation,” said Anjan Thakor, PhD., finance professor at the Olin School of Business. “When they buy at inflated prices they lose, and when they sell at inflated prices they gain. However, while they stand to be compensated for their losses, they don’t have to pay for any gains they made from selling the inflated stocks, so that once they’re compensated for their losses, many actually come out ahead.

Anjan Thakor

Thakor said that the injustice of the system is made worse because the actual transfer of the payment is not a neutral process either. Huge resources are used paying the lawyers and accountants who handled the litigation. After you pay all expenses, undiversified individual investors end up with maybe three cents on the dollar.

“The settlement doesn’t help the shareholders who paid the fine because they’re paying out of their own pocket. It doesn’t really help the individual undiversified shareholders who sued company, who recover mere pennies on the dollar, after expenses. So who made the money? Large institutional investors handling more than $100 million in assets, the lawyers and the accountants,” Thakor said.

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 discomforting because the Private Securities Litigation Reform Act of 1995 was an attempt to promote transparency in corporate activities and prevent fraud, both of which are laudable objectives.

In Thakor’s opinion, it’s time to re-examine the act, incorporating ways to appropriately punish those who committed the wrongdoing. The focus ought to be on getting managers to comply because they’re the ones making the decisions so we can have a transparent and efficient financial market.

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