The kernel of truth in Lerach’s ethics sermon

November 14, 2007, 12:43 AM UTC

In his 1,500 word sermon in Sunday’s Washington Post, shareholder class-action impresario Bill Lerach argued that “the legal system is a lot tougher on shareholder lawyers than it appears to be on Wall Street executives.” He was referring to the fact that neither Citigroup (C) CEO Chuck Prince nor Merrill Lynch (MER) CEO Stan O’Neal are headed to jail, while Lerach is. (For his article, click here.)

I’m not going to spend much time addressing the thrust of that argument, except to note in passing that the sparse dataset he relied upon did not seem sufficient to prove his thesis. Neither Prince nor O’Neal, who each presided over subprime mortgage debacles at their companies, has (yet) been accused of much more than stupidity or mismanagement, which aren’t crimes. Lerach, on the other hand, has pleaded guilty to conspiring to make intentional false statements and obstruct justice in more than 150 court cases during a two-decade period, for which he stands to serve — if a judge accepts on January 14 the terms of his breathtakingly lenient plea agreement — a maximum of only two years. (Former Enron CEO Jeff Skilling is serving 24 years; former Tyco (TYC) chief Dennis Kozlowski is doing 8 1/3 to 25; and former WorldCom CEO Bernie Ebbers is looking at 25.)

Nor was I going to focus on Lerach’s apparently misguided belief that he’s being incarcerated because, as he puts it, “in my zeal to stand up against this kind of corporate greed over the years, I stepped over the line.” In fact, of course, the crimes he has pled guilty to have nothing to do with standing up to corporate greed. They relate to undermining the rights of the investor classes he ostensibly represented (by providing secret payoffs to their named representatives) and using illegal means to gain a competitive advantage over rival firms in the plaintiffs bar (who were also theoretically trying to fight corporate greed).

I was writing instead to focus on a telling and refreshing concession in the piece. After discussing how big O’Neal’s and Prince’s salaries were (unconscionably large, but fully disclosed), he recounts how much money their inattentiveness or incompetence has cost shareholders. “The previously reported profits have been wiped out,” he writes, “and rumors of billions more in coming write-offs abound.” Then comes the capper: “Who knows what the class-action suits against Merrill and Citi for stock fraud will cost?”

Well, exactly. But let’s drill down on that last insight. What he’s saying is that the innocent Citi and Merrill shareholders whose fate he is bewailing are about to lose even more money because they will have to foot the bill for the defense attorneys fees and settlement payments and increased insurance premiums being brought down upon those companies by the shareholder class-action suits that are reflexively coming down the pike. Shareholder suits brought by lawyers who aspire to become the next Bill Lerach.

Getting confused? You should be. You’re noticing something distinctive about Lerach’s life’s work, and it’s something that’s true even if you were to assume, for the sake of argument, that all of his cases were actually nonfrivolous — i.e., arguably had merit. The weird thing about those cases is this: Most of them probably didn’t benefit most of the people for whom they were brought.

There’s actually a remarkable consensus about that fact in legal academia today. Here’s why.

In the typical fraud suit prompted by a sudden drop in stock price, the vast majority of investors who get hurt—i.e., the ones who bought when the stock price was allegedly inflated by the fraud, and sold after it had fallen back to true value—purchased their stock from other innocent investors. Those innocent sellers inadvertently benefited from the fraud (i.e., they sold at an artificially inflated price), but the law does not require them to cough-up their windfalls. Instead, the injured investors go after the corporation itself for their reimbursement. But everything the corporation pays as a consequence—attorneys fees, insurance premiums, settlements, judgments—ends up hurting its current shareholders, who also happen to be innocent of any wrongdoing.

It gets worse. In real life, most diversified investors, like pension funds and mutual funds, aren’t harmed by most securities frauds to begin with. If a pension fund holds a portfolio of 1,000 stocks, and 100 of those companies are accused of fraud in a given year, the fund most likely will be a net buyer (i.e., loser) as to 50 of those inflated stocks, but a net seller (i.e., winner) as to the other 50. Empirical studies appear to confirm that the majority of diversified investors—which is the vast majority of all investors—don’t suffer net damages. Any compensation they receive from lawsuits is overcompensation.

What about the undiversified investors—the widows and orphans? Too often private shareholder suits don’t help them either. Undiversified investors are typically “buy-and-hold” investors. To be a class member, though, investors must have bought their stock during the period when the alleged fraud was in effect, which is usually less than a year before the date of the price drop. Buy-and-hold investors will often have bought too early to qualify.

In August six influential law professors—four of whom are generally considered moderate-to-liberal on shareholder issues—wrote SEC chairman Christopher Cox urging him to convene a series of roundtable discussions on these subjects with a view to proposing reforms. The letter, authored by Donald Langevoort of Georgetown University Law Center, emphasized the professors’ unanimous concern about the “immense amount of ‘pocket-shifting’” that is currently occurring (i.e., innocent investors senselessly paying innocent investors, with much of the money being lost to attorneys fees en route), and the need to pay “more attention to the burden imposed on smaller investors whose inactive trading makes it more likely they will be funding the pay-outs than receiving them.” The professors’ letter is available here.

The SEC general counsel Brian Cartwright wrote back indicating that these were just the sorts of issues the Commission hopes to look into in an upcoming “formal roundtable” it wants to convene “to explore the topics of private securities litigation, its relationship to Commission enforcement efforts, and its effects on U.S. capital markets, competitiveness, shareholder value, and investor protection.” (The precise schedule and agenda has not yet been announced.)

It’s a welcome development. Too bad it won’t come in time to protect those poor Citi and Merrill shareholders from the drubbing Lerach acknowledges they’re about to sustain from benefactors like him.