Capital Markets

Subprime Mess Overtakes GAAP Gaffes

Litigious investors zeroed in on the mortgage crisis last year, and alleged fewer accounting missteps, says a new report.
Sarah JohnsonJanuary 4, 2008

Allegations of accounting violations in securities class-action lawsuits waned last year, according to a new review of the 2007 filings. The percentage of complaints accusing companies of violating generally accepted accounting principles made up only 42 percent of federal filings, compared with 66 percent in 2006, notes a new report from Stanford Law School Securities Class Action Clearinghouse and Cornerstone Research.

“This decline seems to suggest a movement away from the focus in recent years on the validity of financial results and accounting treatment,” the report’s authors wrote.

So where did securities lawyers focus their attention last year if not on accounting? Not surprisingly, the subprime-mortgage market took up some of the slack. Indeed, nearly 20 percent of all securities suits filed were tied to subprime issues. In effect, these cases “have caused a shift in emphasis from allegations related to traditional income statement line items to allegations related to balance sheet components,” concluded the authors, who released the report last week.

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The subprime cases contributed to the 43 percent jump in securities class-action suits from 2006 to 2007, leading the authors to deflect assumptions that there’s an upward trend of activity from the plaintiffs bar. Rather, the report attributes much of the upsurge to the latter half of 2007, when 100 companies were sued, some of them following the subprime-market fallout and the subsequent volatility in the stock markets.

During the summer, when only 59 filings had been made by the six-month mark — reflecting a 42 percent drop from the average semiannual filing rate of 101 in the past decade — Joseph Grundfest, a professor and director of the Stanford Clearinghouse, connected the lower number of filings with fewer incidents of corporate fraud and a strong stock market. So despite the surge in suits at the end of the year, which brought the 2007 total to 166 lawsuits from 116 in 2006, litigation activity is down when compared with the decade’s average. Indeed, the total number of shareholder suits filed in 2007 fell 14 percent below the average recorded in the past 10 years, Grundfest’s report notes.

With that in mind, Stanford and Cornerstone Research are sticking to their midyear theory on the current state of the litigation environment: that the heyday for securities lawyers has passed. Despite recent market volatility caused by the meltdown in the subprime-mortgage sector, Grundfest is holding on to his belief that a “permanent shift” is a afoot in securities suits, mainly due to the hypothesis that federal enforcement activity and increased scrutiny by boards have led to less fraud in recent years. In addition, he notes that new research has shown that managers have become more conservative and more accurate in their financial reporting since the corporate scandals earlier this decade.

To support their prediction that lawyers will file fewer securities filings in the future, Grundfest and his co-authors subtracted the 32 subprime-related suits from the 2007 numbers, leaving a “core litigation rate” that ignores one-time events, such as the options-backdating scandals (which made up eight of the filings last year). The adjusted numbers suggest that “litigation activity remains well below historical norms,” according to Grundfest.

But other experts disagree with Grundfest’s prediction. For example, economic consultancy NERA recently suggested that the sharp rise in securities suits marks an upward trend, following an 18-month decline.

Kevin Lacroix, a director of OakBridge Insurance Services and an observer of securities litigation, also believes the lawsuit lull is over: he predicts the upward trend will continue into 2008. While he supports Grundfest’s findings overall, he takes issue with the professor’s disregard for one-time events in his analysis.

Over time, securities markets have been hit by such one-time scandals, including the subprime mess, backdating, and laddering (when investors bought shares in the aftermarket at specified prices in exchange for initial public offering allocations). Therefore, they can’t be ignored when factoring in a company’s risk exposure to lawsuits, Lacroix told

At the same time, he says “only time will tell” whose theory will be borne out, when more — or fewer — suits are filed during the next few years. Indeed, Grundfest acknowledges that more data collected over several years is needed to “assert with any real statistical confidence that there is a decline in the filing rate that can be attributed to a reduction in the incidence of alleged frauds.”