Top of Mind: Shareholder Lawsuits Climb Upward in 2007

Despite the falloff in options backdating cases -- only a handful have been filed this year -- the storm clouds have been gathering on the securities litigation horizon for some time now. A September study by PricewaterhouseCoopers counted 57 federal class action filings in the first half of the year, compared with 106 for all of 2006. But a flurry of fourth-quarter filings provides the strongest evidence to date that the lull in shareholder lawsuits is over.

Fallout from the subprime crisis figured largely in the new cases. In October, for example, shareholders of financial services provider E*Trade Financial Corp. filed suit against the company, alleging that it had overvalued its securities portfolio and failed to disclose delinquency rates in its mortgage and home equity holdings. On October 30, Merrill Lynch & Co. was slapped with a class action complaint claiming that it had failed to disclose information about its collateralized debt obligations. Two days later, the embattled investment bank found itself confronting a shareholder derivative suit alleging breach of fiduciary duty, corporate waste, and abuse of control in connection with the losses it sustained as a result of those obligations.

Next up was Washington Mutual Inc., targeted by shareholders unhappy with what they claimed were "false and misleading" statements about the bank's exposure to $57 billion worth of adjustable rate mortgages and option-ARM loans, as well as a stock price slide that followed its announcement that it would set aside up to $1.3 billion in the fourth quarter to cover loan losses.

On average, 202 securities class action cases were filed annually from 1994 to 2004, according to economic and financial consulting firm Cornerstone Research. But Kevin M. LaCroix, author of the D&O Diary, an online journal, and director of Oakbridge Insurance Services in Beachwood, Ohio, expects this year's filings to beat that figure easily. Based on his count of 61 new filings between August 1 and October 31, he projects a total of 244 filings for 2007. "Recent turbulence in the financial markets, among other factors, clearly has led to renewed litigation activity at, or even above, historical levels," he notes. "The likelihood of continued financial marketplace instability suggests that litigation levels may remain elevated for some time to come."

A sustained downturn in the equity markets could raise the level of securities class action filings. "When you have the market going up and down more, then individual companies also tend to be quite volatile, and we know that securities class action cases are typically filed after some sizable trough in the stock price," explains Alexander Aganin, a principal with Cornerstone Research. "If the market is generally going up and volatility is low, then -- other things being equal -- you would expect to see fewer large drops that might warrant filing a class action lawsuit."

Plaintiff law firms carefully assess the potential costs and benefits of each case, Aganin adds. "If they see a small drop, they evaluate the potential recovery and their cut of the recovery and then compare it against the expenses that they would have to incur. Sometimes it doesn't make sense for them to file that particular lawsuit."

With the current turmoil in the economy showing no signs of slacking, it might be unwise to count on this happening very frequently in the months ahead.