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In Class-Action Lawsuits, You're Only Suing Yourself

Feeling let down by that financial firm you invested in? New research suggests class-action lawsuits should go after the people responsible for your loss, not the company.

Feeling let down by a financial firm?

These days, you’re probably not alone. While you may have a hard time retaliating against Goldman Sachs (although their stock prices are down, most shareholders have still posted profits), new research by law professors Lynn Bai, James D. Cox and Randall S. Thomas suggests that you may want to rethink your class-action lawsuit, anyway.

Their paper, to be published in the upcoming edition of University of Pennsylvania Law Review, indicates that these suits should target the people responsible for a financial loss and not the company they work for. With a financial reform bill on the horizon, Congress may want to consider their research.

The typical securities class-action lawsuit goes like this: stock prices drop, law firms jump to find affected shareholders (unless, of course, you’re Milberg Weiss), lawyers file suit against company, company loses money, shareholders get some money back. But typically the bad guys — the ones who were responsible for the price drop in the first place — get off scot-free, bonuses in hand, while the corporation and its shareholders (including you!) suffer.

There are two schools of thought on the usefulness of class-action suits. Some believe that the threat of action prevents financial firms from engaging in unsound practices. Others argue that these lawsuits put American corporations at a competitive disadvantage internationally and don’t do much to help wronged investors.

Bai, Cox and Thomas argue that, for these suits to be effective, shareholders looking to sue should go after the individuals responsible for their losses instead. They found that the long-term damage done to a corporation in a class-action suit can impact its future viability, which ultimately has repercussions for anyone who still has holdings with the company. Targeting the people most at fault could help realign the incentives of these suits, especially considering that many high-level employees make millions in salaries and bonuses every year.

It makes sense — if you’re going to personally pay for your wrongdoing, you’re probably less likely to do it in the first place. Plus, holding a few people financially accountable for their actions could go a long way toward discouraging bad behavior by their peers in the future.

“Class actions hurt the reputation of the corporation, distract the attention of the management and, to the extent that settlement is reached, this money may come, at least partially, out of the corporation’s pocket, rather than the pocket of the insurance company,” Bai says.

The researchers examined the impact that class-action suits had on 480 companies who had recently settled suits in which they were the defendants. They compared the sales, operating income, liquidity, financial distress levels and stock market performances of these companies to others of similar size in the same industries.

While the research both supports and denies the usefulness of class-action lawsuits, it shows clearly that the suits are bad for both the companies being sued and their shareholders; Bai points out that because her team didn’t include companies that went bankrupt before or during the settlement process, the consequences of these suits could be even greater than the study shows.

So next time your portfolio takes a plunge, think before seeking revenge on the corporation you invested in — ultimately, you might only be suing yourself.