In Defense Of Securities Class Actions

Former shareholders of Chaparral Resources should receive the proceeds of the settlement with Lukoil (LUKOY) in the next few days. The settlement checks were mailed on Monday, we were told by a lawyer involved in the case. We have written about Lukoil’s shenanigans in the acquisition of Chaparral Resources before. As majority shareholder, Lukoil manipulated Chaparral to depress its stock price and acquire it at a low price. Shareholders filed a class action and are now, two years after the fact, finally receiving compensation.

Martin Lipton

Martin Lipton

Class action lawsuits have a bad rep. Martin Lipton, inventor of the poison pill, labels them “a type of extortion.” It certainly didn’t help when the largest class action firm was indicted over illegal kickbacks paid to plaintiffs.

So we figured it was time for a dispassionate Deal Sleuth look at class action lawsuits’ merits or lack thereof. As our regular readers know, we dabble a lot in mergers and have chronicled it all: conflicts of interest, management manipulating production to lower earnings and the stock price for a cheaper buyout, nonsensical fairness opinions, fairness opinions that valued companies much higher than their buyout price, forcing a sale at a low price to private equity, and much more.

Mergers are the scenarios where latent conflicts of interest become a problem for shareholders. The stakes are high and the incentives are stacked against outsiders and in favor of management that is trying to get the firm on the cheap. It is not unusual for a CEO of a lossmaking firm to take it private it for a steal, arguing that the future is uncertain and that shareholders are better off with cash. We never quite understood why someone would want to buy a firm whose outlook is so bleak, and our suspicion is only confirmed by some of the recent settlements of class action litigation around mergers:

  • In the above mentioned buyout of Chaparral Resources by Lukoil, shareholders will receive close to an additional $2.50 per share through a class action. That is in addition to the $5.80 that Lukoil was willing to pay in the buyout. Readers who have missed the story may want to read our original post.
  • Shareholders of Foodarama Supermarkets were paid initially only $53 per share, but stand to receive another $14 per share after a class action lawsuit against the management buyout group
  • When Restoration Hardware was acquired by management and private equity funds after it spurred a higher bid from Eddie Lampert’s Sears Holdings (SHLD), shareholders received and extra $0.19 payout through a class action.
  • Former shareholders of National Home Health Care Corp, which was acquired by Angelo Gordon last year, received an extra payout of $0.10 per share, or just over one extra quarterly dividend payment, thanks to litigation brought by Helaba Invest Kapitalanlagegesellschaft, an investment advisory subsidiary of state-owned Hessische Landesbank.

One of the leading arguments against shareholder litigation is that supposedly settlements monies simply pay one group of former shareholders money that is owned by current shareholders. A form of redistribution of wealth between past and current shareholders. That would be true in cases where the company remains public. But in litigation over a buyout, the funds come from the buyout group and go to the public shareholders. Therefore, it is not a zero sum game but a net gain for public shareholders.

And the question where the gain comes from is an entirely different one. Litigation around the value of an acquisition can only be successful if there is a deep undervaluation of the buyout. In an acquisition where shareholders receive a premium, fair value or even just a little less than fair value, there is not much room for litigation. Merger cases are brought in courts of equity under state law and are heard by professional judges rather than juries. Most cases are heard in Delaware, where courts are biased in favor of management under what they call “business judgment rule.” In essence, the court will defer to management in good faith unless there is egregious misconduct or fraud.

Class actions have the potential to help shareholders recover some of the gains overzealous management buyout groups make when taking public companies private. More importantly, they act as deterrence against the most extreme abuses. Nevertheless, once a buyout is done, the upside is lost for good to managers who should work for shareholders rather than toward their own buyout. Even a class action won’t get it back.

We continue to see the fallout of the recent private equity merger wave. Shareholders who had their companies bought out at low valuations may every know and then have a smile on their face when another settlement payment comes in. Which is just the right medicine in the current market.

Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which held positions in the securities mentioned.

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