©2006 Robins, Kaplan, Miller & Ciresi L.L.P.
Dr. Anjan V. Thakor recently authored two articles for the U.S. Chamber Institute for Legal Reform regarding securities litigation titled: The Economic Reality of Securities Class Action Litigation and The Unintended Consequences of Securities Litigation. Dr. Thakor concludes that "large institutional investors are, in fact, overcompensated as a result of [securities] litigation." An unstated, implicit conclusion of Dr. Thakor appears to be that institutional investors should not pursue securities litigation.
However, all securities litigation cases are not created equal. While Dr. Thakor may have some valid points, the final conclusions are oversimplified and fail to capture the nuances of different kinds of securities litigation. When securities litigation is segregated into different categories, it is clear that there are specific instances in which institutional investors should pursue litigation to recover assets.
Dr. Thakor's Main Premise
Dr. Thakor's main premise is that "diversified investors – such as large institutional investors-who 'lose' on one transaction (i.e., from buying a security at what is alleged to be an artificially inflated price) are eligible to recover damages under the law while they are, at the same time, permitted to keep gains received from separate ‘winning’ transactions (i.e., from selling a security at what is alleged to be an artificially inflated price.)" Therefore, the net "benefit" to the institutional shareholder is neither a gain nor a loss, but basically a wash.
This premise appears to be based on the assumption that all securities transactions have a buyer and seller unrelated to a company. However, not all securities transactions included in class action securities litigation cases are between entities unrelated to the company – for example, bond and structured debt, IPO and private placements of stock are sold by the company.
This premise also incorporates an equal measurement of "loss" and "gain". Further, it appears that Dr. Thakor’s premise assumes that the companies will continue to operate after the class action securities litigation. When a company files bankruptcy or otherwise ceases to operate, such equal measurement of "lose" and "gain" may not exist. In such cases the "lose" is frequently greater than the "winning" amount of trades in non-bankrupt companies.
Different Types of Securities Litigation
Securities litigation should be viewed from many different points of view. After analyzing the different types of securities litigation, it is clear that the netting of “winning” and “losing” transactions is an oversimplification which can lead to implicit conclusions that are not warranted and are misleading.
It does not appear that Dr. Thakor appropriately considered at least four categories of securities litigation; rather, these distinct types of securities litigation are "netted" with all other securities litigation. The result is to discourage appropriate securities litigation for institutional investors.
At least four categories where institutional investors should consider litigation include:
Bondholders and Structured Debt
Bondholders and structured debt
IPO and direct equity purchasers
Illegal financial fraud versus information-disclosure-related litigation, and
Systemic fraud perpetrated over a number of years.
Bondholders and structured debt holders are part of certain securities class action settlements. It appears that Dr. Thakor did not attempt to remove the bondholders or structured debt portion of the settlement proceeds in the class actions used in his analysis. Bondholders and structured debt holders should be viewed differently than equity holders.
Generally, bondholders and structured debt holders do not have the ability to produce “winning” transactions which can be offset against losses. Institutional investors that invest in bonds, particularly section 144A bonds, and in structured debt generally buy these financial instruments to hold rather than resell and are frequently held only by the original purchaser. Finally, the recipients of cash proceeds from issuance of these types of securities are the company (and its sales agents, underwriters and, indirectly, its auditors), not another institutional investor.
Therefore, institutional investors that are bondholders and structured debt holders which have suffered losses due to financial fraud, generally, can only recover losses through securities litigation and not through the netting of “winning” transactions from other bond purchases.
IPO and Private Equity Purchases
IPO and privately-placed equity are different than equity purchased on the secondary market. We concur with Dr. Thakor’s position when he states that "to the extent net trading losses do result from alleged securities fraud, they arise primarily from the issuance of new common shares while the alleged fraud is ongoing." The issuance of new shares can exist in an IPO or may be a private placement of equity including additional shares within a publicly-traded company.
Purchasers of IPO or privately-placed equity are the initial purchasers. There are not other institutional investors which “benefited” from the sale of the securities rather it was the company that benefited from the sale. Also, as with the bondholders, the recipients of the cash proceeds from an IPO or private placement of equity are the company (and its sales agents, underwriters and, indirectly, its auditors), not another institutional investor.
Therefore, institutional investors that purchase equity in an IPO or a private offering and that has suffered losses due to financial fraud, generally, can only pursue recovery of losses through securities litigation and not through the netting of "winning" transactions from other IPO or privately-placed equity purchases.
Illegal Financial Fraud versus Information-disclosure-related Litigation
There is a significant difference between the so-called "information-disclosure-related" litigation and litigation for illegal fraudulent financial activities that essentially eliminates the value of an institutional investor’s holdings in a company.
An "information-disclosure-related litigation" example is the reduction in stock price due to a release of negative information; however, the company continues to exist without the benefit of bankruptcy or other major reorganization. Dr. Thakor may have some valid points related to this type of “information-disclosure-related” securities class action litigation. However, Dr. Thakor’s premises fall apart when considered in the context of illegal financial fraud which eliminates the value of an institutional investor’s holdings. Some recent examples include: Enron, Parmalat and, most recently, Refco, Inc.
Securities litigation in which the entire value of an investment is eliminated due to illegal financial fraud is more similar to a ponzi scheme. In a ponzi scheme, the first parties into the investment usually receive their investment back plus some outsized return on their investment (a purported “winning” transaction). The knowledge of the outsized returns causes other investors to purchase the investment. At the end of the run, the investors still holding the ponzi scheme investment will be damaged without the ability to recover unless litigation is pursued to recover assets from the perpetrators and those entities that assist the perpetrators. Such is also the case in which illegal financial fraud brings ruin to a company. Securities litigation is a method to recover assets when financial fraud causes an investment to be worthless.
The recovery of losses in a ponzi scheme is not attained by going back to the first investors that received outsized returns or “winning” transaction on their investment, but to attempt to recover assets from the perpetrators of the ponzi scheme and those entities that assisted the perpetrators. Such is the case in the securities litigation where the investment has become worthless. The appropriate place to recover such losses is from the perpetrators and other involved entities.
The mere netting of ponzi-type “winning” transactions with ponzi-type “losses” does not vindicate a perpetrator of a ponzi scheme, or illegal financial fraud, from being liable to the “losing” investors. Quite the contrary, it is appropriate to litigate to recover assets from the perpetrator and those entities that assisted the perpetrators. In securities litigation, it would be inappropriate to suggest that the “losing” shareholder should not litigate to recover losses from illegal financial fraud since they may have unwittingly obtained “winning” transactions from some other illegal financial fraud activities.
Therefore, institutional investors that purchase equity which becomes worthless due to illegal financial fraud activities may wish to pursue recovery of losses through securities litigation.
Systemic Fraud Perpetrated Over a Number of Years
A final category that needs to be considered is when systemic fraud is perpetrated over a number of years, particularly when a company is faced with negative information and continues to refute such information – only to finally admit the negative information is correct. Systemic fraud such as this may produce “winning” transactions similar to the analysis of Dr. Thakor. However, not dissuading such behavior by seeking to recover losses may serve to perpetuate systemic fraud. Therefore, cases involving systemic fraud should be based on the individual situation and the egregiousness of the systemic fraud.
Therefore, institutional investors that purchase equity in a company in which systemic fraud is present may unwittingly receive some “winning” transaction, but may wish to seek recovery of assets from the company and its officers and directors to further dissuade the systemic fraud.
While Dr. Thakor does have some valid points, the final conclusions are oversimplified and fail to capture the different kinds of securities litigation. When securities litigation is segregated into different categories, it is clear that there are specific instances in which institutional investors should pursue litigation to recover assets.
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