How to avoid a securities class action
For years, the U.S. Chamber of Commerce has pressed Congress to restrict securities class action lawsuits, saying they put a damper on economic activity. Securities lawyers argue that such suits act as a crucial protection for investors, who deserve their day in court when deceitful actions by executives cost them money.
Now, some new research sheds light on this question.
Jonathan Rogers, an associate professor of accounting at the University of Chicago’s Booth School of Business, led an investigation into why some companies get sued while others do not.
Rogers, his Booth colleague Sarah Zechman and Andrew Van Buskirk of Ohio State University identified 165 companies that were sued because their share price fell after an earnings statement had pointed to strong future performance.
Booth and his coauthors then did something that I think added real value. They paired each of their 165 companies with a company in the same industry that was not sued, matching them for size and performance. Then they compared the earnings announcements of the two groups.
So why were 165 companies sued, but 165 similar companies were not?
First, the companies that were sued made unusually optimistic remarks about their future earnings, according to the paper, in the current issue of the American Accounting Association’s Accounting Review.
UPBEAT WORDS INVITE SUITS
They used words like “excited,” “strong” and “thrilled,” and these words were frequently quoted in securities fraud complaints, the researchers found. The firms that were not sued used these words less often and made more use of words such as “weak.”
The researchers concluded that optimistic words elevated the chance of litigation slightly. But what really raised the odds was an optimistic announcement followed by a sale of stock by company insiders, they found.
“Optimistic language can get you sued,” Rogers told me, “but what’s significant is optimistic language followed by abnormal insider stock sales.”
Bragging about performance while selling lots of stock seems a fairly obvious formula for getting sued, so why has this lesson not been universally learned in executive suites?
For an answer, I turned to Gregory Roussel, a Silicon Valley corporate lawyer and former editor of the Vanderbilt Law Review, who has coached executives on how to talk up their companies without inviting litigation.
Roussel said executives are reluctant to dial back their remarks. “They are enthusiastic about their company and they believe what they are saying,” Roussel said, suggesting that excessive optimism rather than deception is to blame.
Corporations that are being sued often assert that optimistic statements are not material representations and therefore not subject to the 1934 Securities Exchange Act, which requires disclosure of facts an investor would need to make investment decisions. Call it the corporate puffery defense.
Increasingly, judges think investors can distinguish such puffery from material statements and they have become more hostile to such class action lawsuits, according to David Hoffman, a professor of law at Temple University who has researched this field. As a result, “being a class actions securities litigator is a lot less lucrative than it was not many years ago,” Hoffman said.
So, can investors distinguish puffery from substance?
Stefan Padfield, a professor at the University of Akron School of Law who blogs about corporate governance, thinks not.
In a 2008 research paper on corporate puffery, Padfield found that judges generally embrace the ancient doctrine of caveat emptor. Under that doctrine, a farmer who buys a plow horse based on sales talk — instead of an inspection of its mouth and fetlocks — shouldn’t come crying to the courts if the horse turns out to be old and lame. But, Padfield found, 45 law students and professors who had made investment decisions regarded executive statements as material far more often than the judges believed.
Having bought both horses and stocks, I think Padfield’s conclusion makes sense. A work horse is not as complex or difficult to appraise as a stock.
There is a lesson here for Corporate America: companies should make their insiders put proceeds from stock sales into escrow for some period of time — 90 days ought to do it — after upbeat executive statements. If the price drops during that time, make them take the lower price or wait until the price recovers. After all, the law requires directors and executives to put company interests ahead of their own.