Unscrewing Shareholders

Courtesy : Daniel Fisher - Forbes

By throwing out the SEC's settlement with Bank of America, a New York judge raises ugly questions about securities fraud cases.


A federal judge in New York got his dander up about a practice that is routine in courts around the country: making shareholders pay twice for securities fraud.

In a blistering ruling released Monday, U.S. District Judge Jed Rakoff rejected a settlement between Bank of America ( BAC - news - people ) and the Securities and Exchange Commission over $5.8 billion in bonuses it paid to Merrill Lynch employees last year, allegedly without warning shareholders. In that settlement, BofA denied lying to shareholders but agreed to pay the SEC $33 million and to never do it again.

This struck Rakoff as unfair. Why should shareholders hand the government $33 million to settle claims that management hid information from them?

“To have the victims of the violation pay an additional penalty for their own victimization was enough to give the Court pause,” Rakoff wrote in an acid 13-page ruling.

The ironic part is this is exactly what happens in most securities fraud cases. A company’s stock price falls, the class-action lawyers file a complaint, and after months of expensive pretrial jousting, the parties settle with the company’s shareholders picking up the tab. The fact that insurance is often the source of the money doesn’t change things: Insurance companies aren’t charities--they collect those payouts by increasing rates.

The most egregious examples are so-called derivative suits, in which the class-action lawyers sue management, supposedly on behalf of the company itself. Settlements rarely come in the form of cash paid by human managers. They often consist of minor changes in the wording of corporate governance documents or pledges, like Bank of America's promise to the SEC never to do it again. Lawyers justify the settlements--which yield them cash fees--as helping to improve the quality of management.

I agree with the judge that the shareholders should not have to pay twice. The problem is that Ken Lewis was deceived, and when he tried to back out of the deal to buy Merrill-Lynch,

One California law firm, Robbins Umeda, seems to specialize in this sort of litigation. Coincidentally, its targets are sometimes the same companies being sued for shareholder fraud (a different type of claim, made by investors against the company) by another San Diego firm, Coughlin Stoia Geller Rudman & Robbins. (The founder of Coughlin Stoia, William Lerach, is in jail for paying plaintiffs to gain control of securities class-action cases.)

In the Bank of America case, Rakoff ridiculed the idea that the payment of shareholder money to the government would somehow make the bank a better company.
“The notion that Bank of America shareholders, having been lied to blatantly in connection with the multi billion-dollar purchase of a huge, nearly bankrupt company, need to lose another $33 million of their money in order to 'better assess the quality and performance of management’ is absurd,” he said.

Rakoff has taken a jaundiced view of securities class action tactics in the past. In an April hearing, he blasted lawyers for the Iron Workers union over the common practice of “portfolio monitoring,” where plaintiff lawyers install software to watch the holdings of pension funds and tip them to suddenly falling prices that might yield a claim.
Rakoff called the practice “as obvious an instance of conflict of interest as I have ever encountered in my life,” because it gave lawyers ostensibly working for the pension fund an incentive to advise them to sue. When a lawyer noted that the practice is widely used, Rakoff said, “well, I’m being educated.”

“So you think this inherent conflict of interest exists throughout the United States?” he asked. “And what authority can you bring to my attention that says it’s not a blatant, flagrant conflict of interest?”

In the Bank of America ruling, Rakoff noted that normally a civil settlement is “close to unreviewable” because society prefers opponents to settle their disputes out of court. But in this case, Rakoff said, the SEC was asking his court to use its contempt powers to enforce the agreement by BofA to never repeat what it didn’t admit to doing in the first place.

That gave him the opportunity to probe into the terms of the settlement, which was announced the same day the SEC filed suit. Rakoff criticized the government for failing to target individual executives who allegedly hid the agreement to pay Merrill bonuses from shareholders. If, as the SEC said, they were protected because they relied on legal advice, Rakoff asked, why not go after the lawyers?

He also criticized Bank of America for agreeing to pay $33 million to settle a case it said was without merit.

“It is one thing for management to exercise its business judgment to determine how much of its shareholders' money should be used to settle a case brought by former shareholders or third parties,” Rakoff said. “It is quite something else for the very management that is accused of having lied to its shareholders to determine how much of those victims’ money should be used to make the case against the management go away.”

In closing, Rakoff offered both sides a challenge: Try this case, and let the truth emerge. He instructed them to prepare for a trial date of Feb. 1.