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The Fraud Never Stopped: Securities Class Action Filings See Significant Increase

There are those who assert that the decline in US-based securities class action filings during the 18 month span, covering the second half of 2005 and all of 2006, is attributable to some notion that corporate wrongdoers have learned from past high-profile misconduct and are, therefore, engaging in less fraud. Regrettably, calendar year 2007 demonstrated that this simply is not the case.

In 2007, securities class action filings increased 49% from 2006 as securities fraud and corporate misconduct once again dominated the headlines. Most notably, the collapse of the subprime mortgage industry took centre stage in 2007, revealing massive securities and consumer fraud by lenders, developers and banks. As a result of the collapse, banks announced write downs of over $40 billion for losses from mortgage-backed securities tied to subprime lending. Many of these banks concealed or misrepresented the extent of their exposure to investments backed by subprime mortgages. Also in 2007, hundreds of companies were involved in ongoing investigations and litigation for failing to properly disclose, both in SEC filings and financial records, excessive stock option backdating practices, as well as tax and other law violations. Backdating scandals gained worldwide attention as executives of blue chip corporations such as Brocade Communications Systems Inc.’s former Chairman, President and Chief Executive Officer Gregory Reyes, were found criminally liable and sentenced to extensive prison terms because of their role in furthering their company’s backdating practices.
 
Securities fraud involving subprime lending and stock option backdating practices are recent examples of how corporate wrongdoers continue to develop and implement fraudulent business practices aimed at increasing their own profits at the expense of investors while artificially inflating stock prices in violation of the US securities laws. The recent wave of high profile corporate scandals act as vivid reminders of the lengths some will go to mislead investors. As these schemes are exposed and the truth is uncovered, it is incumbent on institutional investors in particular to closely monitor their portfolios including equities and other investment vehicles such as options, notes and collateralised debt obligations, in order to protect the assets of their schemes and maximise recoveries from US based securities (group) class actions.

Class Actions On The Rise

In 2006, securities class actions in the United States accounted for a record-breaking $18.3 billion in recoveries on behalf of investors injured through securities law violations. These unprecedented recoveries stemmed from the culmination of securities class actions filed as much as five years prior to reaching settlement or final judgment.  Although 2006 represented an historical year for recoveries, the year also represented a nine-year low for securities class action filings. Only 118 securities class actions were filed in US federal court in 2006. In the latter half of 2005, 69 securities class actions were filed compared to 109 filed in the first half of 2005.





The declining number of filings from the second half of 2005 through the end of 2006 led some to hypothesise that securities class action filings would continue to decline because companies were committing less fraud. The belief was that increased federal enforcement activity during that time and improved monitoring by boards and auditors were successful in curtailing fraudulent conduct. However, the 49% increase in securities class action filings in 2007 from 2006 rebuts that theory. Indeed, securities fraud does not appear to be in decline.

In 2007, 176 securities class actions were filed. Of those 176, 110 were filed in the latter half of 2007, indicating that securities class actions filings are actually on the rise for the foreseeable future. The number of filings in 2007, however, does not necessarily mean that more corporate fraud was committed in 2007 than in 2005 and 2006. The increase in filings indicates that more corporate fraud was uncovered in 2007 than in the previous two years. The fact that there were fewer class action filings in 2005 and 2006 does not indicate that companies were not making false and misleading statements in their SEC filings and other public disclosures, including press releases and analyst conference calls, during that time. In fact, a majority of the securities class actions filed in 2007 allege securities law violations for fraud committed by defendant corporations at some point during either 2005 or 2006. Clearly, the number of filings in a given year does not necessarily reflect the amount of actual fraud being perpetrated by wrongdoers in the securities markets at that particular time.

Uncovering Securities Fraud

The securities laws in the United States were enacted to protect the integrity of the country’s financial markets and to ensure the accuracy and timeliness of financial information disseminated to the domestic and foreign investing public. Unfortunately, external and internal pressures facing corporate insiders and board members, combined with what can be an overwhelming selfish desire for increased profits, lead many companies to employ business practices that clearly violate established securities laws.  These companies have readily hidden material adverse information and manipulated SEC filings and financial reports to overstate assets and revenues, while understating costs and liabilities.

To illustrate, in the late 1990s until early in this decade, when market activity was at never before seen levels, corporate executives experienced tremendous pressure to maintain stock prices high, even if that required fraudulent accounting and reporting as evidenced by the collapses of Enron and Worldcom, to name a few. Additionally, in the aftermath of the inevitable recession that followed, corporate managers were compelled to portray their companies in the most favourable light. The illusion of prosperity and financial stability was, and continues to be, often created through outright fraud and misrepresentation or ‘creative’ accounting and financial reporting practices.

As time passes and more misconduct is uncovered, the creative corporate wrongdoers become more sophisticated in developing and implementing schemes designed to deceive the investing public. Despite new regulations, like the Sarbanes-Oxley Act of 2002, which requires board of directors and auditors to improve their internal monitoring and oversight procedures, those insistent on ignoring the legal obligations adapt and continue to implement sophisticated schemes to deceive. Such carefully planned schemes can become routine business practice for years without detection.  

While US federal regulators, including the Federal Bureau of Investigations (‘FBI’) and the US Securities & Exchange Commission (‘SEC’), can expose illegal and fraudulent conduct, limited resources prevent these agencies from identifying all but a fraction of companies and individuals engaged in fraudulent activity. Often fraudulent activity is discovered only after a company’s performance forces it to reveal the truth. For instance, a company that implements an ongoing scheme to prematurely recognize revenue in its financial statements and SEC filings may be forced to announce that it will have to restate its previous filings, which typically results in large drops in market capitalisation and significant losses for investors. Also, fraud can be uncovered as the financial market or a particular industry begins to collapse. In 2007, the credit crisis and subsequent subprime mor