Executive Fraud Blog

Plaintiffs allege that Clear Channel monopolized the market for tickets to rock concerts and therefore caused those ticket buyers to pay more for their tickets to Clear Channel's rock concerts. The class action lawsuit has been filed in the following cities: Los Angeles, Chicago, Boston, New York and Denver.

Last year a 15 member commission was created by the US Chamber of Commerce to evaluate the effects of litigation & regulation on the US capital market. Tom Donohue, the CEO of the Chamber, is a powerful business lobbyist that has become critical of the implementation of Sarbanes Oxley (SarBox) especially section 404 which covers the assessment of internal controls.

The question remains: Is the litigious US business environment driving away foreign investment in US public companies? Has SarBox section 404 caused these declines and how could it be changed to build confidence but retain assurance of the efficiency of internal controls?

Despite the criticisms in the report, the Securities and Exchange Commission's (SEC) Christopher Cox has responded with an acknowledgement of the difficulties of SarBox but an emphasis on the new changes. The Complete Act of 2007 recommends a limitation of section 404 that only requires the internal control audit on a three year basis. Another change proposed attempts to reduce the costs of these 404 audits for smaller companies by making them voluntary. There is also a movement to rely more heavily on the internal audit function for an assessment of lower risk internal controls.

By changing the rules for implementation the SEC feels that it would appropriately mitigate the costs to firms for their audit AND reduce their exposure to unwarranted securities fraud lawsuits.

The SouthWest Exchange fraud is an interesting example of a class action lawsuit that has exploited the favorable tax treatment of appreciated property sales. Donald McGhan of California was the mastermind of the fraud scheme that cost shareholders over $80 million in losses.

SouthWest Exchange was set up as a exchange accommodater that acts in a similar manner as a bank in that they will hold the housing sale funds in a trust until they are used again to purchase another property. As long as the money is used within 180 days of the original sale the income qualifies for a 1031 exchange and is not taxable up to certain limits. Since the original owner may not possess the money during this period there is an open opportunity for a lapping scheme. In this case, after a sale is made if the original seller does not reinvest the money until the later part of the 180 days the accommodater has the opportunity to defraud them. The timing differences can be exploited by using new money to pay out to earlier depositors. As the money exchanges hands there is a billing for fees from the accommodater but since they are not a bank they are not required to disclose as much about the fees therefore could overbill users.

After the money was skimmed from the customers the fraud continued by McGhan's money laundering plot. In order to get the money out, McGhan created shell companies that would launder the money to allow removal for him and his accomplices. Eventually, like all lapping schemes the fraud fell apart as business slowed and the real estate market cooled off causing less deposits and more reinvestments. Users of this service are the source of the class action lawsuit that will attempt to recover the damages.

Possible Reasons for the Decline of Filings
1.The passage of Sarbanes-Oxley (SOX) in 2002
SOX has public companies on the forefront of documenting controls and establishing corporate governance. Some think that this oversight has limited fraud therefore there is less of a need for shareholder class actions. Although the research considers the differences across industries and court circuits there is not supporting evidence that proves a correlation of SOX regulation to the decrease in federal filings.

2.Law firms that are the largest filers are currently tied up in legal battles
Firms such as Milberg Weiss have been subject to high profile federal trials that have led to serious losses for their partnership. Lerach Coughlin on the other hand has had much of their resources tied up with the Enron case that has turned into the largest settlement to date and the costs are still adding up. If it were the case that firms were having limited resource problems therefore unable to file lawsuits then the public could suspect a rise in litigation as these suits pan out. Although contrary to this argument, it would seem to be true that firms of this size would not have trouble mobilizing a large offensive for promising cases thus there must be a lack of eye-opening opportunities.

3.Significant increases in dismissal rates of lawsuits
Beginning since the 1995 passage of the Private Securities Litigation Reform Act (PSLRA) the number of dismissals of cases filed has nearly doubled. In recent years dismissals have been the result of 38.2% of cases filed. Although the rates vary by court and seem relatively high according to the research the numbers may be misleading because they incorporate those that may have been subsequently appealed or reversed.

Although any number of possibilities may explain the decrease in filings, I contend the law firms limited resources and dismissal rate arguments fail to account for the corporate response to outside litigation. After witnessing what has been done to companies that have disclosed irregularities publicly before disseminating the information it is quite possible that corporations have begun handling issues in house. Once information regarding a potential threat is released the door flies open for class action suits if there is any drastic change in stock price therefore the decrease in filings could be a result of better communication of facts to the public. Uncertain circumstances create volatility in the stock price thus efficient communication of known facts and resolutions could create fewer filings than the announcement of an accounting investigation with no further details.

Although the SOX explanation is criticized by the statistical research I think acknowledging it as a factor is important. In the short term it is possible that SOX has encouraged corporations to realize the importance of governance even if compliance is related to the media’s coverage of the SOX penalties. Since the largest settlements have resulted in corporate liquidations it is possible that investors are wary of tanking their investment for the reward of pennies on the dollar for their shares received through litigation. Since there has been such as substantial change in settlement amounts it is important to evaluate the reasons why.

Possible Reasons for the Variation in Settlements
1.Investor losses – 50% explanation, single most powerful predictors

2.Accounting firms are a co-defendant
Since SOX and scandals like Enron, the legal system, jurors, and the media have been very critical about the professional ethics of accountants. It is not surprising that the average settlement involving accounting firms is nearly double if they were not involved. It is also expected to be a higher settlement if there are allegations of accounting improprieties but if they are deemed irregularities then it is expected to increase even further. A reason for this seems to be pockets of multinational accounting firms are deeper then some of the clients in the lawsuit. The accounting restatements that seem to follow these situations have less of an impression on settlements which is thought to be a nature of their commonality.

3.Cases with any kind of official investigation, consent decree or penalty

4.Institutional investors have become the lead plaintiffs
In most cases with institutional investors are lead plaintiffs as a result of PSLRA therefore their active role has allowed smaller investors to recover 1/3 more than they would have without them. The reasons for this success are suggested by the research to be caused by their better counsel, their ability to supervise their counsel better, or their ability to provide an independent contribution to the plaintiff’s strategy.

5.Involvement of an IPO – under Section 11 have lower burden of proof then 10-b(5)