After two years of below-average filings of securities lawsuits, has that trend reversed?
Between Aug. 1 and Sept. 21, investors sued 37 companies, according to The D&O Diary, a weblog written by Kevin LaCroix, a lawyer with OakBridge Insurance Services. That rate of new lawsuits translates to an annual total of 296, which well exceeds historical averages. During the week of Sept. 17 to 21, eight companies were hit with first-time lawsuits, LaCroix noted.
Investors filed most of these new suits against subprime lenders and homebuilders, which saw their shares plunge after the collapse of the subprime mortgage market earlier this year. Investors also have targeted Moody's and McGraw-Hill, the parent of Standard & Poor's, accusing the rating firms of giving excessively high ratings to mortgage-backed securities. Investors also sued Bear Stearns, which operated two hedge funds that collapsed after investing in subprime mortgage securities.
In addition, lender Countrywide, homebuilder Beazer Homes, and Freemont General have been sued by their own employees over losses they suffered in their 401(k) accounts through their holding of company shares.
Overall, shareholders had filed 130 federal securities lawsuits as of late September, up from 100 during the same period in 2006, according to Securities Class Action Services data.
Meanwhile, defense law firms, which last year touted new practice groups to address stock option backdating, have been gearing up teams of professionals to address the fallout from the subprime mortgage market.
A Quiet First Half of 2007
This surge in new securities cases follows a rather quiet first six months of 2007, when investors brought lawsuits against 59 companies, according to a mid-year report released in July by Stanford Law School and Cornerstone Research. That total was 42 percent lower than the average filing rate from late 1996 through June 2005, and the first half of 2007 marked the fourth consecutive six-month period when new case filings have trailed that historical average, the report said. (For more on the Stanford-Cornerstone report, please see the August 2007 issue of the SCAS Alert.)
Another group of researchers, NERA Economic Consulting, recorded 76 federal cases as of June 30, and projected a total of 152 cases for the whole year. That total would be 12 percent more than the 136 cases in 2006, but it would still trail the more than 200 cases that were brought each year from 1997 to 2005, NERA noted in its mid-year report, which was released Sept. 13.
History suggests that the recent surge in lawsuits may be a temporary phenomenon, and future case filings may return to 2006 levels after investors file all their subprime-related lawsuits. For instance, the option backdating scandal spawned 22 federal securities lawsuits in 2006, but was the subject of just four lawsuits this year, the NERA report noted.
In 2001, investors filed more than 300 IPO-laddering cases, causing the total case filings to soar to 520, according to NERA. That surge in IPO-laddering cases was short-lived; during the next three years, total cases ranged from 251 to 280 per year, which were only slightly higher than the 237 to 270 cases filed annually in 1998 to 2000.
Unless the subprime mortgage crisis leads to a widespread collapse of corporate credit markets and a broader recession, it appears that the recent flurry of subprime-related lawsuits will result in just a temporary increase in litigation activity.
"Certainly, the collapse of the 1990s stock market bubble led to an active period of class action litigation filings and settlements--a similar drop in market values in the future might lead to a resurgence in filings, even in a post-[Sarbanes-Oxley Act] world," the NERA report noted.
Will Settlement Values Decline?
The NERA report also predicts that settlement values may start trending downward after reaching a record high this year. The median settlement during the first six months of this year was $9 million, up from $7 million in both 2006 and 2005, according to NERA.
The NERA researchers base this prediction on recent declines in the median investor loss, which historically has been a "strong predictor" of settlement values. For cases that settled in 2007, the median loss was $381 million, less than the $407 million median loss for cases that were resolved in 2006. This trend is also apparent if one looks at new lawsuit filings. The median investor loss for cases filed in 2007 was $240 million, down from $265 million in 2006 and $340 million in 2005.
In addition, the percentage of accounting-related cases (which tend to have higher settlement values) has declined. As of June 30, 26 percent of new cases included accounting allegations, as compared with 57 percent in 2006 and 48 percent in 2005, according to NERA.
"These trends are early hints that recent filings might not lead to continued increasing average settlement values in the future, although it is still too early to know which of the recently filed cases will result in settlement as opposed to dismissal," the NERA researchers explain.
Uncertain Future for Subprime Lawsuits
The investors bringing these new subprime-related lawsuits will have to overcome various legal hurdles before they can obtain any significant settlements. For instance, Professor John Coffee of Columbia University noted that investors have never been able to recover damages from credit-rating firms. Even in the case of Enron, where the rating firms didn't cut their ratings on the energy firm until four days before it filed for bankruptcy in 2001, Enron investors were unable to obtain any money from the rating firms, Coffee told The Washington Post.
While the U.S. Supreme Court in 1994 barred claims against "aiders and abettors" of securities fraud, investors have argued that they should be able to sue investment banks third parties who knowingly help companies mislead shareholders. (The Supreme Court now is considering another case that raises this "scheme liability" theory; for more details, please see the "In The News" section of this month's newsletter.) The liability of these third parties is a significant issue; investment banks accounted for most of the multibillion settlements obtained by WorldCom and Enron investors.
The lawsuits with the best chance of success presumably will be those that assert direct claims against company officials over statements (or omissions) about corporate finances or the risks of their subprime portfolios. Nevertheless, the investor plaintiffs will still have to point to allegations that "give rise to a strong inference of fraud" to survive a motion to dismiss.
In recent years, dismissal rates have gradually increased, perhaps because of the Supreme Court's 2005 Dura Pharmaceuticals decision, which made it more difficult for investors to bring "fraud on the market" cases. Of the cases filed between 2001 and 2005, 39.1 percent are dismissed within two years, the NERA report found.