Wall Street to Fraud Street: Disgruntled Investors Want Compensation

I. Introduction

With the financial crisis showing no signs of recovery many are worried about employment, job security, investments, and the overall economy. With the collapse of Lehman Brothers Holdings, the buyout of Merrill Lynch along with several other Wall Street firms, and the government bailout of American International Group, many are beginning to reevaluate and question Wall Street and the executives that run the corporations.[1] While the Bush administration was proposing a $700 billion bailout plan, investors began to point fingers at the wealthy corporate executives that pocketed millions of dollars while the companies they worked for crumbled.[2] Although there are several factors that played a part in the Wall Street crisis, investors are lining up to sue the executives with the deep pockets.[3] Two major issue at the center of heated discussion are: fiduciary duty and executive compensation.[4][5] 

II. Fiduciary Duty


A. Fiduciary Duty and Rise in Litigation

Corporate executives, as a member of the board of directors, have a fiduciary duty to the shareholders’ of a corporation.[6]  Trust and confidence are place in the directors of a corporation, and they are relied upon to exercise discretion and expertise to act in the best interest of the shareholders.[7] Persons acting in a fiduciary capacity are held to a high standard of honesty and full disclosure in regards to the shareholders. [8] Corporate executives, as fiduciaries, must act in the best interest of the corporation and its investors by exercising skill, care, and diligence at the disposal of his self-interest when acting on behalf of the shareholders.[9]

As the financial crisis rapidly unfolded and confidence in the market was disintegrating, the fiduciary duties of the Wall Street executives became the center of attention.[10] The investors and the public began to question whether the wealthy executives of the large companies played a major role in crashing many large Wall Street firms to the ground.[11]  Investors now are claiming that corporate directors breached their fiduciary duties by selling the companies too cheaply.[12] Many companies including American International Group, Morgan Stanley, Lehman Brothers Holdings, and Washington Mutual were hit with lawsuits as the crisis in Wall Street only grew in late September 2008, and many other lawsuits are predicted to follow.[13] 

The main complaint in recent shareholder suits since the Wall Street crisis is that the fiduciaries, the corporate executives, misrepresented the companies’ financial position, understated their exposure to mortgage-related investments, and inflated losses in the company.[14] Further, the investors are alleging that these kinds of executive misrepresentation led to major losses for the shareholders.[15] Especially in September, many corporations experienced a large drop in stock value because of the depressed market conditions, and companies were left with no choice but to cooperate in mergers.[16] The plummet in the stock market coupled with continuing corporate mergers, furthered the investors’ suspicion that corporate directors were intentionally driving down stock value in order to make dealings with other corporations to sell the companies at a cheaper price.[17] Shareholders are alleging that the executives and their decisions caused investors to lose millions of dollars, while executives collected on their multimillion dollar severance packages. [18] Lehman Brothers Holdings is currently under investigation for this very issue. Officials are investigating on whether Lehman Brothers Holdings mislead the public by announcing their intentions to file for bankruptcy and effectively drove their stock value to the floor. [19]

B. Shareholder Suits and Recent Developments

Executives accused of fraudulently inflating their corporate losses are now facing criminal charges.[20] Under federal guidelines, someone engaged in securities fraud can be convicted for zero to six months in prison; however, a variety of factors can increase the time behind bars. The factors include: the size of shareholder losses, the number of victims, and whether a defendant is an officer or director at a public company.[21] In these shareholder suits, both sides retain financial experts to determine how much shareholder harm are directly tied to the fraudulent inflation of a corporation’s loss reserves.[22] 

It is not easy for investors to get compensated for their losses through litigation. Investors have several legal obstacles they must overcome.  Investors have to prove that their losses were because of managerial fraud and not a result of the ordinary fluctuations in the market.[23] Recently two major Supreme Court decisions have made it even more difficult for investors to bring fraud claims against corporate executives.[24]

The first obstacle comes from a 2005 ruling.[25] The Supreme Court held that alleging a director’s general misrepresentation caused inflated share prices and therefore loss to shareholders, is insufficient for a fraud claim.[26] The Supreme Court ruled that an investor must prove that their losses were caused by a particular fraud, and not other market forces.[27] This first obstacle makes it harder for investors to bring a claim because fluctuation and volatility is something that is embedded in the financial market.[28] Pointing to a particular fraud, an oral or written statement, to prove that a company’s misrepresentation caused the stock to rise or fall is a difficult task.[29]  Also, these suits are difficult argue because companies can easily argue that the drop in the stock market were the effects of a unforeseeable market crisis.[30]  The second obstacle that investors must overcome arises from a 2008 Supreme Court decision.[31]  The Court held that fraud claims can no longer be brought against secondary actors such as lawyers, accountants, and other third parties involved in the “scheme” of deceit.[32] Scheme liability is no longer upheld because the Court ruled that secondary actors are too far removed from the deceit for shareholders to show reliance.[33] These recent changes in securities law benefit businesses and corporations but make it much more difficult for investors to bring claims.[34]

III. Executive Compensation

Executive compensation is another area of concern in the current crisis.[35] Overpaid corporate executives is not a new area of concern in corporate America.[36] The main reason why this issue is brought to light now is because, as Wall Street firms are collapsing, the executives of those firm’s are walking away with more than enough money in their pockets.[37] For example, while Lehman Brothers Holdings filed for bankruptcy and their stock plummeted, Lehman Brothers’ CEO Richard Fuld pocketed approximately $480 million since 2000.[38]  It is also reported that Lehman Brothers Holdings agreed to pay $23 million to three executives just days before its collapse.[39] As the Bush administration pushed for the $700 billion bailout plan, congress leaders pushed to have the Treasury set standards to prevent excessive executive compensation.[40] Initially the three main approaches included: first, limiting severance packages; second, giving shareholders an advisory vote on executive pay; and finally, giving companies more authority to claw back bonuses.[41] 

First, severance packages is a common feature in merely every executive employment contract.[42] The current proposal would not only limits severance packages, but it would also require companies participating in the bailout plan to ban severance pay for the next two years.[43] Second, the proposed changes would require that companies set up an advisory board composed of a company’s shareholders.[44] Under the proposal, the advisory board would annually vote on the top executives and pay them accordingly. [45] Although critics say that a similar system is already in place in the Untied Kingdom and the provisions have not stopped executive pay, supporters argue that this system better ties performance with awards.[46] Finally, there is a trend of having a claw-back provision be included in the executive pay agreement.[47] A claw-back provision requires that an execute give up pay or severance when it is found that corporate results were misstated.[48] Although a claw-back provision was part of the Sarbanes-Oxley law, because it is difficult to apply and hardly used, there has been a movement to include a claw-back provision in the executive-pay agreement itself.[49]

IV. Conclusion

The current financial crisis has many investors concerned about the future Wall Street. Whether it is fiduciary duties or excessive pay, it is evident that the entire system, including corporate firms, financial institutions, and government agencies, need reconstruction, reform, and regulation. Corporate executives have the responsibility of putting the best interest of the company and its shareholder’s above anything else, and in the past few months there have been many allegations insisting that the priorities of Wall Street and its executives are misplaced. With the current economy and the distressed market, it is the responsibility of the executives and the regulatory agencies to help regain the public’s trust and gradually rebuild public confidence in the market.

Endnotes:

[1] Nathan Koppel, For Lawyers, No Shortage of Work Expected in Wake of Tumult, WALL ST. J., Sept. 20, 2008, available at http://online.wsj.com/article/SB122186718155258889.html 

[2] Phred Dvorak and Joann Lublin, Curbs on Pay Advanced in Bailout Plan, WALL ST. J., Sept. 26, 2008, available at http://online.wsj.com/article/SB122238191984476765.html

[3] Koppel, supra note 1.

[4] Id.

[5] Dvorak, supra note 2.

[6] Restatement (Third) of Agency § 8.01 (2006).

[7] Id.

[8] Id.

[9] Id.

[10] Koppel, supra note 1.

[11] Id.

[12] Id.

[13] Id.

[14] Carrick Mollenkamp, Susanne Craig, Jeffery McCracken & Jon Hilsenrath, The Two Faces of Lehman’s Fall, WALL ST.J., Oct. 6, 2008, available at http://online.wsj.com/article/SB122324937648006103.html.

[15] Id.

[16] Koppel, supra note 1.

[17] Id.

[18] Andrew Ross Sorkin, If This Won’t Kill the Bonus, What Will? N.Y. TIMES, Oct. 7, 2008, available at http://dealbook.blogs.nytimes.com/2008/10/07/if-this-wont-kill-the-bonus-what-will/?scp=6&sq=suing%20wall%20street%20executives&st=cse

[19] Mollenkamp, supra note 14.

[20] Michael Orey, AIG Fraud Case: Using the Market to Set Jail Terms, BUS. WK. , Oct. 16, 2008, available at http://www.businessweek.com/magazine/content/08_43/b4105072898725.htm?chan=top+news_top+news+index+-+temp_news+%2B+analysis.

[21] Id.

[22] Id.

[23] Koppel, supra note 1.

[24] Id.

[25] Id.

[26] Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336, 342 (2005).

[27] Id. at 345-46.

[28] Linda Greenhouse, Securities Fraud Standards Upheld by Supreme Court, N.Y. TIMES, Apr. 20, 2005, available at http://www.nytimes.com/2005/04/20/business/20bizcourt.html.

[29] Id.

[30] Id.

[31] Koppel, supra note 1.

[32] Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, 76 USLW 4039 (2008).

[33] David Savage, Ruling Limits Reach of Investor Suits, L.A. TIMES, Jan. 16, 2008, at A-1, available at http://articles.latimes.com/2008/jan/16/business/fi-scotus16.

[34] Koppel, supra note 1.

 

 

 

[35] Theo Francis, Wall Street Bailout Could Crimp CEO Pay, BUS. WK., Sept 23, 2008, available at http://www.businessweek.com/bwdaily/dnflash/content/sep2008/db20080922_190806.htm.

[36] Id.

[37] Sorkin, supra note 18.

[38] Susan Craig, Lawmakers Lay into Lehman CEO, WALL ST. J., Oct. 7, 2008, available at http://online.wsj.com/article/SB122330315664407727.html 

 

 

[39] Id.

 

[40] Dvorak, supra note 2.

[41] Id.

[42] Id.

[43] Francis, supra note 35.

[44] Dvorak, supra note 2.

[45] Id.

[46] Id.

[47] Id.

[48] Francis, supra note 35.

[49] Id.

 

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