The Cure for Corporate Wrongdoing: Class Actions vs. Individual Prosecutions

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Lithograph by Honoré Daumier, 1847

In 2009, the Securities and Exchange Commission charged that the top executives of Bank of America, in connection with asking their shareholders to approve the bank’s $50 billion acquisition of Merrill Lynch, defrauded those shareholders by failing to reveal the full extent of Merrill’s huge and growing losses and by secretly agreeing to pay Merrill’s executives year-end bonuses of up to $5.8 billion. That is, the SEC charged that the bank was obliged by law to reveal these important facts to its shareholders and did not. If the shareholders had known these facts, they might have voted against the acquisition.

The SEC, which sued only the bank and none of its executives, settled the case in early 2010 for $150 million, to be paid to the defrauded shareholders. Meanwhile, however, a private class action on behalf of those same shareholders was brought against the bank and certain of its officers and directors, based on the same allegations. To mount such a suit requires considerable effort, usually undertaken and financed by law firms that specialize in such cases. The class action was settled in 2012 for $2.4 billion, or sixteen times the SEC settlement.

At first glance, this would suggest that the private class action was a much better vehicle for bringing justice to the victims of the alleged fraud (which the bank and its management “neither admitted nor denied”) than the relatively paltry efforts of the SEC. Many other similar cases over the past two decades would seem to suggest the same. For example, in 2002, the SEC settled its fraud cases against Enron for $450 million, while the parallel class action was settled for $7.2 billion, or again about sixteen times the SEC settlement.

More recently, in 2010, the SEC settled for $75 million its case against Citigroup for concealing the riskiness of the securitized mortgages sold by the bank, while the parallel class actions were settled for $1.3 billion, or more than seventeen times the SEC settlement. In an even more extreme example, the SEC in 2006 settled its fraud case against Tyco—in which two executives were shown to have illegally taken $600 million—for $50 million while the parallel class action was settled for $3.2 billion, or a full sixty-four times the SEC settlement.

But the story is not quite that simple. In most such class action suits, the monies awarded to the victim shareholders are paid not by the executives responsible for the frauds, but by the companies themselves—which means, in effect, by the current shareholders (or, if the company is in bankruptcy, by its secured creditors).

These current shareholders (or other stakeholders) are as blameless for the fraud as the shareholders they are paying. Indeed, in many instances they are classic small shareholders who purchased their shares before the fraud (and are therefore not part of the plaintiff class) and held…


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