The Class Action Machine

lawsuitThe recent troubles at Wells Fargo raised a number of questions in the mind of one of our Chapter members about the class action lawsuits that seem to immediately follow public announcement of such financially involved frauds.  Specifically, she asked about who among the various classes of defendants in a typical financial fraud case are most likely to get sued after the fact.

As I’m sure most financial professionals know, a class action is a type of lawsuit in which a single representative individual is permitted to sue on behalf of an entire group of similarly situated individuals known as a “class.” A class action theoretically comes about when an aggrieved shareholder (or in Wells Fargo’s case a shareholder or perhaps a type of defrauded account holder) contacts a lawyer and explains that s/he has been harmed. The law then generally permits that single party to sue on behalf of all similar share or account holders. Although the common conceptual justification for class action litigation begins with a single aggrieved affected individual reaching out to a lawyer to seek redress, the reality is somewhat different. As our Chapter member indicated she is aware, shareholder class action litigation tends to be prosecuted by a small number of highly specialized law firms and, over the years, these firms have developed practices and relationships that enable them to take the lead in commencing shareholder litigation almost on their own. A practical consequence is that, within days after issuance of a press release revealing financial fraud, the class action lawyers will normally have their lawsuits already prepared.

The catalyst for commencement of the litigation will often be the company’s initial press release announcing the fraud. Among other things, the lawyers may glean from the press release that accounting irregularities have surfaced, that earlier SEC filings are false, which line items on the financial statements are affected, and the board of directors’ preliminary information as to how far back the accounting irregularities go. With that information in hand, the class action lawyers will quickly extract from their word processors an earlier complaint filed in a similar case and quickly insert the specifics regarding the particular company at hand. In their haste to be the first firm to file a lawsuit, the process of revision is not always completely thorough and factual errors are common in almost all initial filings.

Although an exposition in detail of all the steps involved in such a suit are beyond the scope of this short post, the following are the typical steps that unfold during the process:

  • The company’s initial press release;
  • The company’s receipt of a series of complaints;
  • Production of a single consolidated complaint;
  • Motion to dismiss by the defendant company;
  • Document productions;
  • Depositions;
  • Settlement (if necessary);
  • Trial (almost never).

From the perspective of the board of directors, the result will be that, within several days of the issuance of the company’s initial press release, the company will begin receiving a number of seemingly duplicative lawsuits in which the only significant difference seems to be the name of the representative shareholder seeking to represent the interests of the class. In truth, a shareholder gains no meaningful strategic advantage over the defendants in rushing to be named the class representative. In the end, only one class of similarly situated shareholders will be certified and only one complaint ordinarily will survive.  Rather than trying to get a strategic advantage over the defendants, the interest of a plaintiff in rushing to be named the class representative is to get an advantage over the other plaintiff shareholders—or, more precisely, their lawyers. For a class action plaintiff’s lawyer, having one’s client named the class representative opens the door to the lion’s share of the legal fees.

So, to answer our reader’s question, who are the main candidates most likely to get sued in one of these actions?

  • The company. The corporate entity will almost inevitably be named a defendant. Also named may be a parent company or holding company. The plaintiffs will argue that the corporate entity or entities are responsible for the wrongdoing of their individual officers and directors;
  • Officers who have resigned, been terminated, or placed on leave. It may be that the initial press release will have identified particular officers who have resigned, been terminated by the board, or been placed on paid or unpaid leave. The plaintiffs’ lawyers will infer from any such corporate action the officers’ complicity in wrongdoing;
  • The CEO and the CFO. Prime candidates to be included as defendants are the chief executive officer and the chief financial officer. The plaintiffs will infer from their positions some level of complicity. Also, they will have signed what have now turned out to be incorrect SEC filings, such as a Form 10-K or Forms 10-Q;
  • Particular officers. Beyond the CEO and CFO, other officers may be named as defendants depending on the nature of the fraud (as described in the press release) and a particular officer’s proximity to it. For example, if the fraud involved improper revenue recognition (on fraudulently opened accounts, for example), the plaintiffs may seek to include as a defendant the officer or officers with responsibility in the new account generation area. Similarly, if the fraud involved improprieties at some remote location, those responsible for operations or the financial reporting function of that location may be named;
  • Outside directors. These days, outside directors tend not to be included as defendants. Historically, all outside directors would be named as defendants almost as a matter of course. Congress’s passage of federal securities law tort reform in the mid-1990s, however, has operated as an important impediment to the inclusion of the entire board—at least in the absence of evidence suggesting an individual director’s knowledge or complicity;
  • Underwriters. Where the company has publicly issued stock within the last three years, the underwriters may be included. For the corporate issuer, this is particularly unfortunate insofar as typical underwriting documents will provide for corporate indemnification of the underwriter in the absence of the underwriter’s own wrongdoing;
  • Selling shareholders. An issuance of public stock within the prior three years may also open the door to the inclusion as defendants of shareholders who participated as sellers in the offering. Plaintiffs may seek to show their complicity based on inferences drawn from their natural desire to see the stock price sustained or increased during the period prior to their sale;
  • The outside auditor. Several years ago, inclusion of the outside auditor in an accounting irregularities case occurred as a matter of course. Today, the inclusion of the outside auditor as a defendant, at least in the first complaint, has become less automatic. As with the inclusion of outside directors, the federal securities law tort reform legislation in the mid-1990s erected barriers to naming the outside auditor, at least without particularized facts showing auditor complicity. However, the auditor may not be left out forever. An important objective of the plaintiffs will be assembling detailed evidence sufficient to make claims against the auditor stick.

As to the outcome of these type of suits, in the great majority of cases, the parties will come (sooner or later) to a negotiated settlement dollar number.  A canned form of a settlement agreement will emerge from the files of the plaintiff’s law firm marked up to meet the circumstance of the present case and signed, effectively ending the process.

Our thanks to our Chapter member for a thought provoking question!  Please, keep them coming!

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