In this study, Securities Class Actions Compared to Derivative Lawsuits: Evidence from the Stock Option Backdating Litigation on their Relative Disciplining of Fraudster Executives, 35% of the 151 stock option backdating litigation observations included private securities class actions (in addition to derivative lawsuits).  In other words, 35% of the litigation observations were parallel.  In contrast, 65% of the litigation observations were derivative lawsuits (without any private securities class actions).  This provides a unique research opportunity to compare parallel litigation to derivative lawsuits.

The reason the stock option backdating litigation was comprised of both derivative lawsuits and private securities class actions is that the stock option backdating litigation could be viewed as appropriate for either genre of litigation.  On the one hand, the stock option backdating litigation involved executives absconding with more compensation than they were telling the shareholders they were receiving.  That is embezzlement or larceny and fraudulent behavior and improper governance that took assets away from the corporation.  Thus, it could be viewed as the bailiwick of a derivative lawsuit, which addresses wrongs to the corporation.  On the other hand, the financial reporting to the shareholders was fraudulent, since compensation expense was understated, resulting in overall expenses being understated, and net income and earnings per share being overstated.  Thus the stock option backdating litigation could be viewed as appropriate for a private securities class action, except that often the materiality of the resulting overstatement of net income and earnings per share was debatable.

The classic derivative lawsuit provides redress to the wrongs suffered by the corporation.  The classic private securities class action provides redress to the wrongs suffered by the shareholders of the corporation and anyone else who relied on the financial reporting, such as bondholders.  The stock option backdating litigation is unusual if not unique as each litigation could conceivably have been brought as a stand-alone derivative lawsuit or as a parallel litigation (with both a derivative lawsuit and a private securities class action).

Which genre of litigation was better at deterring executive fraud?  The parallel litigation was better.

The parallel litigation, which includes private securities class actions, is positively associated with the forced departure of stock option backdating fraudster executives.  Of the 151 stock option backdating litigation observations, 53 were parallel (they included both private securities class actions and derivative lawsuits) and 98 were derivative-only.  In 29 of the 53 parallel litigations (that included private securities class actions), i.e. 55%, the fraudster executives were forced to depart their companies.  In 20 of the 98 derivative-only litigation observations, i.e. 20%, the fraudster executives were forced to depart their companies.  In multiple logistic regression, which included control variables, the difference was significant at a probability value of .003.

In none of the derivative lawsuits was any monetary recovery given to the shareholders.  In some of the derivative lawsuits a monetary recovery was given by executives or insurance companies to the corporation.  In all of the derivative lawsuits fees were paid to the plaintiff attorneys.  In 38 of the 52 private securities class actions with available data, a monetary recovery was given directly to the shareholders.  The recoveries ranged from $2,000,000 to $926,000,000, with a mean of $71,108,008.  A percentage of the recoveries was given to the plaintiff attorneys.  Interestingly, the larger the monetary recovery given directly to the shareholders, the more likely the fraudster executives were forced to depart their companies.  These results were significant in multiple regression with control variables, at a probability value of .067.

These results complement those of Choi and Pritchard (“SEC Investigations and Securities Class Actions: An Empirical Comparison,” Journal of Empirical Legal Studies, Vol. 13, March 2016), who found evidence that securities class actions are more effective than SEC enforcement actions at forcing out fraudster executives.

Private securities class actions have been disparaged and some seek to undercut their viability, such as the recent attempt in Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014) to  revoke the fraud-on-the-market presumption of reliance that was established in Basic Inc. v. Levinson, 485 U.S. 224 (1998).  The results of this study, as well as the Choi and Pritchard study, suggest that maintaining the viability of private securities class actions is essential for deterring executive fraud.

The preceding post comes to us from Ross D. Fuerman, Associate Professor at the Sawyer Business School at Suffolk University.  The post is based on his paper, which is entitled “Securities Class Actions Compared to Derivative Lawsuits: Evidence from the Stock Option Backdating Litigation on their Relative Disciplining of Fraudster Executives” and available here.