The news struck like a thunderbolt A minority shareholder, unhappy with the drop in the company's stock price, retained a law firm and filed a class action lawsuit. The allegation was that senior management withheld information that the company's stock price would fall -- an accusation that the firm vigorously denied. "Stock prices drop as a matter of course; it's an intrinsic risk of the market," lamented one of the company's senior officers at a hastily convened meeting. But no matter: The lawsuit forced the company to prepare a legal response.
Shareholder-led class action securities lawsuits are a growing threat to public corporations and their chief executives, says Philip Rotner, partner at McCutchen, Doyle, Brown Enersen in San Francisco. "It's an insidious process," says Louis M. Thompson, jr., president and chief operating officer of the National Investor Relations Institute in Washington, D.C. "Ninety percent of these suits are without merit, but because of the way the law is structured, plaintiffs' attorneys are not required to prove what a company did that caused the stock price to drop."
Once a case goes to trial, the plaintiffs' attorneys argue that the stock price drop was foreseeable, and that management failed to alert investors. Under securities laws, the burden of proof for plaintiffs is relatively minimal. For example, under the Securities Act of 1933, a plaintiff need not prove fraud, but only that the company or its officers committed a "material misrepresentation" or omission regarding the factors affecting the stock's price. These omissions can include failure to disclose officers' lack of business experience; failure to indicate the limited market for the product or the level of competitiveness in the industry and exaggeration of unaudited earnings for the most recent quarter.
Defending the firm can be onerous, with discovery often stretching out for more than a year. The plaintiffs may request every document a company produced. Consequently, the defendant corporation, even if innocent, faces defense costs that can escalate into millions. As a result, most corporations settle out of court -- at an average of $14.1 million, according to the National Economic Research Associates, Inc. …