Shareholder Lawsuits

[Meadmaker]

In the wake of the British Petroleum problem in the Gulf of Mexico, BP's share values have plummeted. Putting 20 billion dollars into escrow probably won't help their future share value.

Because of this, certain large shareholders, such as some pension funds, have announced the intention to sue BP for the losses they are suffering in their investments. Such shareholder lawsuits have become commonplace in American business.

I find such lawsuits baffling, for a very simple reason. Who are they suing? When you own shares in a company, you own the company. You are the company. How can you sue yourself and win?

I feel some sympathy for people who invested in BP and lost money, but who exactly ought to pay them? It was their company that caused the damages. Thankfully, for them, due to the whole concept of a limited liability corporation, the owners, i.e. the stockholders, of BP cannot lose more than their investment, or else those same people who had BP stock in their IRAs would find themselves having to pay damages to shrimp boat captains. However, now that BP is losing money, they shouldn't be allowed to say that someone else should pay them because the company they owned did something that cost a bunch of other people a whole lot of money.

It's another example of a feeling of entitlement in our society. Where did they get the idea that they could share in the profits of the company by buying a piece of it, but were immune from the losses?

 

[Dunstan]

I think you may be mistaken about some of the details.

These are presumably shareholder derivative actions that accuse the directors and officers (D&Os) of breaching their fiduciary duties and/or violating securities laws.

The shareholders are only suing "the corporation" in a technical sense. Since it is the corporation that was damaged by the alleged negligence of the D&Os, it is the corporation that has the right to sue the D&Os and recover damages. But since the corporation is typically run by the D&Os, they don't always bring such claims -- at least, not as often as the shareholders might think they should.

What is technically happening in a derivative suit is that the plaintiff shareholder is suing the D&Os on behalf of the corporation. If the action is successful, the damages don't get paid to the plaintiff shareholder, but to the corporation.

So it's not about suing the company because your investment didn't work out, it's about suing the people who failed to do their jobs. (At least, that's the theory. Of course, some shareholders always think somebody must have screwed up every time a share price drops, and there's been plenty of abuse of derivative litigation over the years.)

 

[bozothedeathmachine]

"investment" = "risk vs. benefit"

Learn the first word, dumba**es.

That's a bit of an over-generalization, especially in light of Dunstan's explanation. But the idea of suing over something where risk is part of the definition boggles the mind.

 

[TragicMonkey]

That's a bit of an over-generalization, especially in light of Dunstan's explanation. But the idea of suing over something where risk is part of the definition boggles the mind.

But there are different kinds of risk. If I go into complicated surgery where the doctor has clearly explained that it might not be successful, and I could well wind up worse than before, that's a risk and I can choose to accept it and sign waivers, and it would be foolish of me to sue afterwards if the worst happened.

But if I go into that surgery and the doctor is drunk and cuts the wrong organ to ribbons and then pours piping hot coffee in there, I think I have more than acceptable grounds for a malpractice suit, even though the surgery was always supposed to be risky.

The shareholders accepted the risk that the company would do badly financially because of market circumstances, not the risk that the people running it would commit crimes or be lunatics or pour piping hot coffee all over the place.

 

[bozothedeathmachine]

Good point.

That's just my kneejerk when I hear of investors suing. This is (hopefully) a special situation of astounding incompetence.

 

[Meadmaker]

I think you may be mistaken about some of the details.

These are presumably shareholder derivative actions that accuse the directors and officers (D&Os) of breaching their fiduciary duties and/or violating securities laws.

If that were the case, that would make sense. However, I don't think that's the case. It could just be sloppy reporting on the part of the media, but they are talking about BP as the defendant.

I know I once received a letter informing me that I had won a class action lawsuit in a shareholder action. The defendant in that case was Xerox corporation. The plaintiffs in the class were anyone who purchased shares between certain dates. That included me. The really odd thing was that I had made money on the stock. During a time when Xerox shares dropped by about 90% of their value, I had purchased at what turned out to be a local minimum, and sold a short time later at a local maximum.

The basis of the lawsuit was indeed that the information in corporate reports was misleading, but it was the corporation itself that was being forced to pay, not the executives allegedly responsible.

 

[Meadmaker]

Dunstan,

Would a case like this one:

http://www.free-press-release.com/news-motorola-inc-hit-by-shareholder-lawsuit-1265845576.html

actually be a shareholder derivative suit? In the press release, Motorola, Inc. is listed as the defendant. (For those not wanting to click, it's a class action lawsuit against Motorola and others, including certain directors, alleging that they misstated the potential for sales on their RAZR phone) This is the sort of lawsuit to which I was referring. The people who bought stock are suing themselves because they lost money.

Unless, of course, they have since divested themselves of that stock, in which case they are suing the suckers who bought it from them.

 

[KingMerv00]

What about a suit for breach of the duty of care?

 

[Dunstan]

If that were the case, that would make sense. However, I don't think that's the case. It could just be sloppy reporting on the part of the media, but they are talking about BP as the defendant.

I know I once received a letter informing me that I had won a class action lawsuit in a shareholder action. The defendant in that case was Xerox corporation. The plaintiffs in the class were anyone who purchased shares between certain dates. That included me. The really odd thing was that I had made money on the stock. During a time when Xerox shares dropped by about 90% of their value, I had purchased at what turned out to be a local minimum, and sold a short time later at a local maximum.

The basis of the lawsuit was indeed that the information in corporate reports was misleading, but it was the corporation itself that was being forced to pay, not the executives allegedly responsible.

That sounds like a lawsuit for violation of Rule 10b-5 of the Securities Exchange Act. It is essentially an anti-fraud rule. If a corporation has misled you into purchasing its stock, then you really haven't made an informed decision to take whatever risks caused your loss.

What you're complaining about in your OP is analogous to suing the person who sold you a house two years ago because the housing market subsequently crashed. A (legitimate) 10b-5 action is more like suing the seller because they told you the foundation was solid, when in fact they knew otherwise and gave you a false inspection report. I trust you have no moral objection to the latter kind of lawsuit.

Dunstan,

Would a case like this one:

http://www.free-press-release.com/news-motorola-inc-hit-by-shareholder-lawsuit-1265845576.html

actually be a shareholder derivative suit? In the press release, Motorola, Inc. is listed as the defendant. (For those not wanting to click, it's a class action lawsuit against Motorola and others, including certain directors, alleging that they misstated the potential for sales on their RAZR phone) This is the sort of lawsuit to which I was referring. The people who bought stock are suing themselves because they lost money.

Unless, of course, they have since divested themselves of that stock, in which case they are suing the suckers who bought it from them.

Sounds like a 10b-5 action to me:

he plaintiff alleges that Motorola, Inc. (NYSE: MOT) and certain of its current and former officers and directors violated the Securities Exchange Act of 1934 by intentionally and knowingly misstating between December 6, 2007 through January 22, 2008 Motorola's 4Q 07 earnings projections and sales demand for its newly-released RAZR2 mobile handset during the 2007 holiday shopping season.

Then on January 22, 2008, Motorola issued a release reporting Motorola's 4Q 07 financial results, followed by an earnings conference held with the investment community later that day, during which this information was finally disclosed to investors. Significantly, so the lawsuit, Motorola's senior executives expressly conceded that they knew the demand for the RAZR2 was lackluster dating back as early as Thanksgiving 2007 - two weeks before December 6, 2007. Defendants also downgraded their 1Q 08 earnings guidance, so the complaint, and as the market reacted to these disclosures, Motorola shares plummeted 18.8%, or $2.31 per share, to close at $10.01 per share, its lowest level in five years, on unusually high volume.

If the allegations are true, then the corporation and its officers materially misstated the condition of the company and effectively defrauded some people into paying a higher price to buy shares than they would have if they'd known the truth.

As to "suing the suckers who bought it from them," the "suckers" would only be those who bought before the true facts were disclosed, and they're members of the plaintiff class. Anyone who bought after the disclosures wasn't misled into anything, so I don't think "sucker" applies.

What about a suit for breach of the duty of care?

That's the kind of derivative action I was speaking of earlier.

I should point out that both derivative and 10b-5 actions* can and do get filed in a knee-jerk fashion. But that, of course, is true of any kind of lawsuit, and it's why we have courts to sort these things out. There are also plenty of legal rules that protect the defendants. The duty of care is subject to the "business judgment rule"; essentially you can't be liable just for making a business decision that turned out badly, or even one that was a sort of a minor mistake -- it has to be fairly egregious or have some element of corruption.

*There are other statutory and regulatory provisions of the securities laws that authorize private lawsuits, but it's not worth getting into now.

 

[KingMerv00]

I should point out that both derivative and 10b-5 actions* can and do get filed in a knee-jerk fashion. But that, of course, is true of any kind of lawsuit, and it's why we have courts to sort these things out. There are also plenty of legal rules that protect the defendants. The duty of care is subject to the "business judgment rule"; essentially you can't be liable just for making a business decision that turned out badly, or even one that was a sort of a minor mistake -- it has to be fairly egregious or have some element of corruption.

All true. I never said they had a good chance of winning.

 

[Meadmaker]

If the allegations are true, then the corporation and its officers materially misstated the condition of the company and effectively defrauded some people into paying a higher price to buy shares than they would have if they'd known the truth.

But the people who bought the shares are now being sued by the people who sold those shares to them.

To use the house analogy, it would be like buying a house, discovering that there was an undisclosed cracked foundation, selling it at a loss, and then turning around and suing the person who bought the house from you.

But it's even worse than that in the case of the BP lawsuit. The people suing are the people who own the company. It would be like buying a house, renting it out to people with the expectation of profit. The renters hold a massive party and cause lots of damage. You sell the house at a loss, and then sue the people who bought it.

The problem with these lawsuits is that when you own stock, you aren't making a loan. You are buying the company. If the company does something that causes the stock's value to go down, you are responsible, because you are the company. I understand the idea that the former owners might have committed fraud before they sold their shares to you, or their representatives on the Board or among the Executives may have committed fraud, and so the idea of going after those individuals involved in that fraud makes some sense, but a shareholder who sues the company is suing himself.

 

[TraneWreck]

I think you may be mistaken about some of the details.

[...]

So it's not about suing the company because your investment didn't work out, it's about suing the people who failed to do their jobs. (At least, that's the theory. Of course, some shareholders always think somebody must have screwed up every time a share price drops, and there's been plenty of abuse of derivative litigation over the years.)

This is true.

"investment" = "risk vs. benefit"

Learn the first word, dumba**es.

That's a bit of an over-generalization, especially in light of Dunstan's explanation. But the idea of suing over something where risk is part of the definition boggles the mind.

It's important to note that these lawsuits don't go anywhere unless extraordinary levels of incompetence or outright malice can be proven. The presumption in favor of managers and members is fairly high. You won't get sued for just screwing up.

As an example, I handled a case where 5 members of an LLC tried to kick out the 6th and force him/her to accept payment significantly lower than the value of the share. When that failed, they tried to destroy the company and reform a new one that did exactly the same thing but excluded one of the members. That willfull destruction was an obvious breach of the members' fiduciary duty to the LLC, itself.

In BP's case, I assume the lawsuit will be based on some type of gross negligence in the handling of the initial repair that led to the explosion as well as the stream of disinformation during the clean up.

 

[TraneWreck]

But the people who bought the shares are now being sued by the people who sold those shares to them.

To use the house analogy, it would be like buying a house, discovering that there was an undisclosed cracked foundation, selling it at a loss, and then turning around and suing the person who bought the house from you.

But it's even worse than that in the case of the BP lawsuit. The people suing are the people who own the company. It would be like buying a house, renting it out to people with the expectation of profit. The renters hold a massive party and cause lots of damage. You sell the house at a loss, and then sue the people who bought it.

The problem with these lawsuits is that when you own stock, you aren't making a loan. You are buying the company. If the company does something that causes the stock's value to go down, you are responsible, because you are the company. I understand the idea that the former owners might have committed fraud before they sold their shares to you, or their representatives on the Board or among the Executives may have committed fraud, and so the idea of going after those individuals involved in that fraud makes some sense, but a shareholder who sues the company is suing himself.

The analogy would be suing the renters that caused the damage, which is something that happens often.

Or, to be more accurate, the shareholder is like the renter of the property: they pay money for a certain benefit, in this case, housing. If the owner of the house renders the location uninhabitable, the renter has legal recourse.

When you buy stock in a company you establish a fiduciary relationship with the managers of that company. They are required by law to act in the best interests of the shareholder. If they're completely inept or engage in fraud, the shareholder has a right to sue on behalf of the company.

 

[Dunstan]

Another thing to consider, Meadmaker, is how you would deal with the situation where a corporation flat-out lies to its shareholders and potential shareholders: misstates profits, claims to have plans that it doesn't, says there is no potential liability when it knows there is, etc. (I'm using these examples because the BP case is a little blurry: if the essence of the complaint is that the plaintiffs are suing over a risk that was inherent to that kind of business, then the problem is simply that they don't have a case. You wouldn't need to change the law.)

You could, of course, rely on regulatory authorities to deal with this. But there's a lot of companies out there making a lot of statements, and the SEC doesn't even seem capable of finding and prosecuting egregious fraud even when it's handed to them on a platter (e.g. Madoff). For better or worse, the U.S. relies on giving private plaintiffs the incentive to detect and prosecute civil fraud. Changing that would require a pretty significant overhaul.

The other alternative is to say that you can only sue the individual officers and directors. That can be tricky, though, because (1) there may be no single individual who can be shown to have committed clear fraud, even though the corporation as a whole did so; and (2) the individuals may be wholly or partly judgment-proof (suing an individual for a $100 million fraud isn't terribly effective if that individual only has a net worth of a couple million).

 

[Meadmaker]

When you buy stock in a company you establish a fiduciary relationship with the managers of that company. They are required by law to act in the best interests of the shareholder. If they're completely inept or engage in fraud, the shareholder has a right to sue on behalf of the company.

I agree, and shareholder derivative suits make sense to me. In that case, the shareholders are suing the managers on behalf of the corporation.

However, when the shareholders sue the corporation itself, what then? Who is the corporation? It is, in fact, the shareholders.

I talked earlier about a case where I, as a member of a class, won a shareholder lawsuit. However, I have been on the losing end, too. In other words, I notice that a stock has dropped dramatically. I decide that the company is worth more than the market value of the stock, so I buy. Then, someone sues the company because, a year before I bought it, the company lost a bunch of money, and the stock they had purchased dropped in value. When they finally decided to sell (which is the time I bought) they had lost most of their investment. So, they sue. Well, who are they suing? They are suing the company, which means they are suing the current shareholders, when means me.

Buy high. Sell low. Sue the guy who bought.

 

[bozothedeathmachine]

It's important to note that these lawsuits don't go anywhere unless extraordinary levels of incompetence or outright malice can be proven.

Malice? No. Incompetence? Perhaps. The Waxman papers certainly make it look that way. Where does "willful negligence" fall on that continuum?

In BP's case, I assume the lawsuit will be based on some type of gross negligence in the handling of the initial repair that led to the explosion as well as the stream of disinformation during the clean up.

Ok, you sort of already answered my above question, except for the "willful" part. Is there a difference between "gross" and "willful" in this case? I honestly don't know in legal terms. Negligence in and of itself seems a passive act. With 760 safety violations, I don't think anyone can argue it was passive neglect.