The Economics of Lawsuits

The United States of America takes pride in its judicial system. According to most American economists, the judicial system of America is the backbone of the American economy. Since property laws are rigidly enforced, and investors are sure that their economic interests will be protected they tend to invest their money in America. The number of class action lawsuits filed every year is used as proof to justify this claim.

In this article, we will have a closer look at what lawsuits are and the effect that they actually have on investors.

Transfer of Wealth

In case of a class action lawsuit, the plaintiffs and the defendants are not really different from one another. A small number of shareholders usually file a class action lawsuit against the all the shareholders. Hence, regardless of whether the lawsuit is won or lost, the money is being transferred within the company itself. Some shareholders benefit at the expense of other shareholders. However, there is no additional wealth created. Class action lawsuits are therefore zero-sum games which enrich some shareholders while impoverishing the others. The entire exercise does not condone the guilty. Instead, it is merely a “pocket shifting” mechanism.

The Real Perpetrators Go Scott Free

Class action lawsuits actually need to be filed against the management of the company. However, the managers are protected by the corporate veil. Hence, the tasks done by the managers are actually considered to be done by the company itself. The end result is that managements defraud companies, pay themselves huge bonuses in the process and leave the organization. Later, when the fraud is detected, the stock prices fall since lawsuits are filed. The perpetrators are never brought to justice. Instead, they are allowed to walk free. This does not really protect investor interest as these executives are likely to repeat the same exercise in another company as well.

Efficient Market Make Prices Fall

Also, class action lawsuits harm companies since they need not be proven true for the company to lose money. As soon as a lawsuit is registered, shareholders take cognizance of the same and reduce the share price valuation accordingly. Hence, the efficient markets ensure that the share prices fall on the very day that the lawsuit is filed. This leads to a barrage of frivolous lawsuits which are meant to engage a company or to slow down its mergers and acquisitions.

Long-Term Damage

Once the share price of a company drops, it tends to stay there for a while. This is because class action lawsuits take months to years to be settled. During that period of time, the market capitalization of the company is reduced. This leads to reduced opportunities during the time frame. Also, some of the resources of the company are diverted towards fighting the legal battle. In effect, the company is suing itself! Hence, this leads to lost focus which leads to lost opportunities and leads to a considerable loss in the long term.

Recovery Happens For Only Part of The Loss

Shareholders lose a lot of money in the “pocket shifting” exercise. It is a known fact that the valuation of the company is reduced by $2 for every $1 that shareholders actually receive as compensation from class action lawsuits. Hence, it is not just one set of shareholders gaining at the expense of the others. Money is being lost, and value is being diluted in the process. A lot of money is lost because the losing company has to pay the legal charges of both the plaintiff as well as the defendant. This can add up to a significant sum. Hence, lawyers are the real beneficiaries of these high profile class action lawsuits.

Distribution of Funds

If the company has lost a lawsuit, they tend to not show any interest as to how the money, which they pay as fine, is distributed amongst shareholders. The task of distribution is left up to the lawyers and the courts. Historical analysis shows that the bigger shareholders tend to take the lion’s share of the money. Hence, in this pocket shifting exercise, the big shareholders and the big lawyers gain at the expense of the small retail investor.

Big Beneficiaries Tend To Be Hedge Funds

Also, it is a known fact that beneficiaries such as hedge funds have used lawsuits to create a drop in the valuation of the shares that they intend to buy. Analysis has shown that these big hedge funds tend to take and change several positions in the stock of the company that they are filing a lawsuit against. Hence, not only do they gain from filing lawsuits and extracting money from the firms, but they also gain by using the information they have about the case to trade on the market and make money

To sum it up, class action lawsuits do not really protect economic interests of all investors. These lawsuits tend to favor the bigger investors disproportionately. Also, bigger investors are known for using the lawsuit as a tool in order to meet their objectives.

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