Getaway drivers may get off scot-free

Do shareholder class actions hurt investors? In suits against third parties, some experts think so - and the SEC is examining the question.

By Roger Parloff, Fortune senior editor

(Fortune Magazine) -- Last month the Supreme Court heard arguments in a case known as Stoneridge Investment v. Scientific-Atlanta, which may prove to be the most important securities case of the decade. Based on the Justices' questions at the Oct. 9 oral argument, a majority think investors should be barred from bringing class-action suits against third parties that allegedly helped a corporation commit a fraud on its shareholders.

In the case of Enron, that might have meant that private plaintiffs lawyers could not have recovered $7.3 billion by going after the likes of Citibank (Charts, Fortune 500) and J.P. Morgan Chase (Charts, Fortune 500), which served as counterparties in fishy deals.


Now the Securities and Exchange Commission plans to take on some even bigger questions. Chairman Christopher Cox has told legislators that the agency will hold roundtable discussions on the way shareholder class actions affect U.S. capital markets, competitiveness, and shareholder value. In other words: Do class actions hurt investors more than they help them, and if so, how can they be fixed?

The Stoneridge case turns on a 1995 law in which Congress decreed that only federal prosecutors and SEC lawyers are allowed to pursue third-party "aiders and abettors" of fraud, while private class-action lawyers are barred from doing so.

On the surface the 1995 law seems unfathomable: Why shouldn't private lawyers be allowed to help investors recoup their losses from aiders and abettors? In a bank heist, for instance, the getaway car driver is just as guilty as the stickup man. But Congress was striking a very crude compromise reflecting deep skepticism about whether shareholder lawsuits really benefit shareholders at all.

Why the skepticism? In the typical fraud suit, 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 doesn't require them to cough up their windfalls.

Instead, the injured investors go after the corporation itself for 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.

Worse still, in real life most diversified investors, like mutual funds, aren't really harmed by securities frauds to begin with. If a 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) of 50 inflated stocks, but a net seller (i.e., winner) when it comes to the other 50. Any compensation to such investors is likely overcompensation.

In August six influential law professors with widely varying political perspectives urged SEC chairman Cox to take up these issues. The letter, written by Donald Langevoort of Georgetown University Law Center, emphasized the "immense amount of 'pocket-shifting'?" that is currently occurring (i.e., innocent investors senselessly paying innocent investors, with much of the money getting siphoned off for attorneys' fees) 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 payouts than receiving them." The SEC wrote back that these were just the sorts of issues it wants to address at the roundtables.

The discussions are welcome, because whatever the Court says in Stoneridge, it will only be adding a gloss on a 12-year-old legislative stopgap. It's time that the SEC reexamined the whole enchilada.  Top of page