Ineffective Remedy: The Securities Class Action
On Friday, the North Carolina Retirement System was named co-lead plaintiff in a class action lawsuit by investors against Facebook. The suit alleges that Facebook did not appropriately disclose its financial condition when it issued stock last May. You may recall that the stock was priced at $38, briefly traded at $45 and then began a painful descent into the upper teens. North Carolina alleges that they lost about $4.1 million out of their $75.9 billion pension plan.
I have always been skeptical about class action lawsuits brought by pension plans and other big institutions, and I was opposed to acting as lead plaintiff when I was CIO for North Carolina. There’s no denying that more than a few corporate managements have injured their shareholders. However, the class action is a lousy remedy. When a large pension plan sues the company, it is basically suing itself. Let’s suppose North Carolina wins the case and Facebook pays out $4.1 million. The payment hurts Facebook, which in turn, harms the value of North Carolina’s continuing ownership of Facebook. Moreover, North Carolina doesn’t get $4.1 million, because it has to pay the attorneys who brought the case.
|Random Meeting (1996)|
What if the lawsuit includes the officers and directors of Facebook? In all likelihood, the company has indemnified those individuals. Thus, the company will pay their legal expenses and any damages. What if the damages have to be paid by an insurance company under a directors and officers (D&O) policy? At least the company isn’t paying the damages. But who do you think owns stock in the insurer? Probably the pension plan.
The conundrum for North Carolina and other investors is that they have to participate in class actions, because if they don’t, they won’t receive their share of any award. In other words, North Carolina’s choice is to participate and basically pay themselves less legal expenses, or do nothing and receive nothing. Given the choice, North Carolina and most other investors wind up participating in class actions.
When I worked with Treasurer Moore, we carefully weighed being lead plaintiff in any number of class action lawsuits. We could never justify it. The attorneys for the lead plaintiff bring the case, but the lead plaintiff doesn’t get any more money than any other investor. The lead plaintiff’s attorneys are potential winners, because they stand to be well paid if the suit succeeds. Meanwhile, North Carolina’s staff carries the burden of monitoring and consulting with the attorneys as the case proceeds. Might as well let someone else be the lead plaintiff.
The Facebook case is particularly odd, because North Carolina’s loss is so small in comparison to the size of the plan. The plan’s loss is only about 5/1000th of 1% of total assets. To put this into context, when its position in Exxon Mobil drops by about fifty cents they suffer about the same amount of damage. So why would North Carolina want to be selected as lead plaintiff? It’s called the speech on the courthouse steps. The lead plaintiff gets to stare into the television cameras and excoriate the defendant. Stern words don’t do anything for the beneficiaries of the pension plan, or any other investors.
In our current system, the class action lawsuit and SEC civil actions are our standard tools for dealing with corporate malfeasance. The settlements and penalties are so low (even when they’re measured in the hundreds of millions of dollars) that all too many companies simply see these actions as a mere cost of doing business. And as I mentioned earlier, the penalties don’t help investors because the company is paying the award or fine with the shareholder’s money.
If you want managers and directors to be more accountable to shareholders, I have two suggestions. First, make managers and directors pay some damages out of their own pockets. Second, send the worst offenders to jail. Opponents of these sanctions argue that officers or directors would be unwilling to serve if they faced jail or personal fines. If the critics are right, it might be a great development. Public corporations are incestuous institutions. Boards are packed with the politically, socially, and economically influential. If they were unwilling to serve, some of us would be more than willing to step up.
In the Facebook case, lawyers opposing North Carolina’s designation pointed out that Erskine Bowles is a supporter of Treasurer Cowell and a board member of both Facebook and its banker, Morgan Stanley. While this wasn’t a good argument for denying North Carolina lead plaintiff status, I think it would be refreshing if this cozy little world were broken up.