Monday, March 5, 2012

Memo to Management: "How to avoid a securities class action"

I had meant to link to this when it hit the wire a few weeks ago and got distracted. Sorry.
The author won the Pulitzer Prize in 2001 for his reporting on the U.S. tax code.
As far as I know he is the only writer to have won with this subject.
From Reuters:
For years, the U.S. Chamber of Commerce has pressed Congress to restrict securities class action lawsuits, saying they put a damper on economic activity.  Securities lawyers argue that such suits act as a crucial protection for investors, who deserve their day in court when deceitful actions by executives cost them money.

Now, some new research sheds light on this question.
Jonathan Rogers, an associate professor of accounting at the University of Chicago’s Booth School of Business, led an investigation into why some companies get sued while others do not.

Rogers, his Booth colleague Sarah Zechman and Andrew Van Buskirk of Ohio State University identified 165 companies that were sued because their share price fell after an earnings statement had pointed to strong future performance.

Booth and his coauthors then did something that I think added real value. They paired each of their 165 companies with a company in the same industry that was not sued, matching them for size and performance. Then they compared the earnings announcements of the two groups.

So why were 165 companies sued, but 165 similar companies were not?

First, the companies that were sued made unusually optimistic remarks about their future earnings, according to the paper, in the current issue of the American Accounting Association’s Accounting Review.

They used words like “excited,” “strong” and “thrilled,” and these words were frequently quoted in securities fraud complaints, the researchers found. The firms that were not sued used these words less often and made more use of words such as “weak.”

The researchers concluded that optimistic words elevated the chance of litigation slightly. But what really raised the odds was an optimistic announcement followed by a sale of stock by company insiders, they found.

“Optimistic language can get you sued,” Rogers told me, “but what’s significant is optimistic language followed by abnormal insider stock sales.”

Bragging about performance while selling lots of stock seems a fairly obvious formula for getting sued, so why has this lesson not been universally learned in executive suites?

For an answer, I turned to Gregory Roussel, a Silicon Valley corporate lawyer and former editor of the Vanderbilt Law Review, who has coached executives on how to talk up their companies without inviting litigation....MORE