Securities Class-Action Suits Sharply Decline

A Stanford study attributes the decline in shareholder lawsuits to Sarbox and a strong stock market but notes that investors are increasingly questioning companies' accounting methods.

Shareholders filed fewer lawsuits last year. The number of securities fraud class actions filed in 2006 plunged by 38 percent, to a total of 110 filings, from 178 the prior year, according to an annual review by the Stanford Law School Securities Class Action Clearinghouse, a joint project between Stanford Law School and Cornerstone Research.

This marks the fewest number of filings in a calendar year since the adoption of the Public Securities Litigation Reform Act of 1995, which was designed to rein in abusive practices in private securities litigation. The decrease in filings is even greater, when compared to the average number of 193 filed from 1996 through 2005.

As the number of suits decline, accounting-related issues continue to account for a growing share of this shrinking pie. For example, the percentage of complaints alleging specific accounting irregularities increased to 68 percent in 2004 from 44 percent in 2005. “This trend continues to suggest that the litigation market is now more focused on the validity of financial results and accounting treatment of a firm’s activities,” the report points out.

It also notes that cases involving “other” accounting allegations jumped from 37 percent of all accounting allegations in 2005 to 63 percent in 2006. Nearly half of the other accounting allegations were related to stock options issuances.

The report further points out that the decrease in securities class action activity in 2006 is even more dramatic when measured by the associated market capitalization losses. For example, in 2006 the total “disclosure dollar loss” (market capitalization losses at the end of the class period, typically the time of the disclosure of the alleged fraud), as measured by Clearinghouse, plummeted 44 percent from $93 billion in 2005 to only $52 billion in 2006.

As a result, the total disclosure dollar loss is now 58 percent below its historic average of $124 billion, and only 21 percent of the historic peak hit back in 2000.

In addition, the total “maximum dollar loss” in 2006 (shareholder losses measured by the largest capitalization decline experienced during the class period) fell from $362 billion in 2005 to $294 billion in 2006. The total maximum dollar loss is now 57 percent below the historic average of $680 billion per year, and only 14 percent of the historic peak back in 2002, according to the report.

The report attributes the decline to three factors. One is a strengthened federal enforcement environment. This is reflected in the 2002 Sarbanes-Oxley Act, and stepped up pressure by the Securities and Exchange Commission and Department of Justice on companies to conduct internal investigations that implicate the individual executives responsible for the fraud, the report asserts. The report suggests this may be reducing the amount of fraud in the market.

Another factor is the recently strong stock market combined with lower stock price volatility, which the report asserts typically reduces the number of cases filed. The third reason is the overwhelming majority of securities fraud class actions that were filed in the late 1990s to the early 2000s are now behind us. “While the boom and bust cycle of this era may have contributed to the peak, the numbers in 2006 are low even when compared to pre-peak activity,” the report asserts.

“These are unprecedented numbers, and my bet is that the private securities fraud litigation market is shrinking because corporations are engaging in less activity that gives plaintiffs an excuse to file a complaint alleging fraud,” said Stanford Law School professor Joseph Grundfest, who is director of the Securities Class Action Clearinghouse and a former SEC commissioner. “The federal government is a much more aggressive adversary than the private bar, and the feds can force a level of compliance that private class action lawyers could never touch. I think we are seeing the effects of a tougher and smarter campaign against white collar fraud by the SEC and Department of Justice.”

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