Monday, February 07, 2011

The plague of shareholder derviative suits

This bothers the heck out of me so here goes. It could be tedious.

For the most part, shareholder derivative lawsuits against corporations are a vehicle for attorney's fees and nothing more than that. They pull resources from presumably productive corporate purposes, like hiring more workers, and convey them to the pockets of a cottage industry, or perhaps it's a mini-mansion industry at this point.

On the surface a shareholder derivative suit is litigation brought by one or more shareholders to remedy a wrong to the corporation. The plaintiff shareholder does not sue on behalf of themselves. They sue in a representative capacity on a course of action that belongs to the corporation but for some reason the corporation, supposedly, is not persuing.

When a plaintiff and the plaintiff's attorney win or settle to their benefit a shareholder derivative lawsuit, the corporation in effect pays itself, from the cash account into the shareholder's equity account(I do not know the exact income statement and tax treatment accounting of this but the concept just put forward is correct). There is a portion of the award or the settlement that the corporation does not pay to itself, and that's the attorney's fees, which generally are awarded at 30% of the penalty.

You get it. The only real beneficiaries of this legal scam are the attorneys. Why is this allowed?

The justification for this type of action is that these suits provide a means for shareholders to enforce claims of the corporation against managing officers and directors of a corporation. In some cases there may be some merit to that rationale but in practice the principle is rare.

Generally speaking, the plaintiff shareholder is not required to have a large stake in the corporation and it is the attorney who identifies a possible derivatives class and then locates a shareholder to play a nominal role in the action. The attorneys receive a fee on a contingent basis if they win or reach a settlement.

At the state level there are various laws that regulate or minimize shareholder derivative suits but a minority of states allow such actions virtually unimpeded. At a national level, Democrats resist any laws of consequence to regulate these suits because - CHOOSE ONE - A. They are a way of curbing corporate abuses of power and of holding corporate managements accountable for their actions B. Trial lawyers are one of the biggest and most reliable sources of the Democratic party and of individual candidates' political funding. Republicans, in general, support regulating and limiting this type of litigation but their ranks are not rock solid on this , as many members of Congress are attorneys and many incumbents on the Republican side of the aisle are also beneficiaries of the trial lawyers' largesse.

It should be obvious that this is a diversion of corporate resources and time that is often completely unproductive. Real abuses of power can be and should be dealt with by regulatory agencies like the SEC or by criminal prosecution in extreme cases. Large corporations, at this point, simply see the shareholder derivative lawsuits, however aggravating, as a cost of doing business that is built into what they charge their customers or taken away from what they pay their workers. If the corporation misses earnings expectations due to a surprise charge or shortfall, some suits will come. If an accountant or trader or other manager makes a serious error, misstates financial information, or is accused of fraud, the floodgates for the suits will open even if senior corporate management and government enforcement agencies are all over the issue.

For smaller companies these lawsuits can threaten their survival. This is especially true in areas like biotech where a company could be working on a specific drug that could be especially effective against some illness, a breakthrough opportunity. If the drug does not pass an FDA phase two trial, as an example, the stock gets hit and the suits that come are, in a way, easy. Since the company was optimistic enough about the prospects for the drug to risk their time and money on the research, certainly along the way they said things to the general public and investors that reflected, however tempered, their optimism. When the trial fails, those words become carved in stone for the trail lawyers. In general, small companies in technology and creative areas who are working to implement new ideas are extremely vulnerable to these predatory lawsuits.

Allowing this charade to go on is simply inexplicable. At least now I no longer feel compelled to write something on the topic. It's done. It's important but it's sort of boring. On to better posts.


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