Private lawsuits are essential for defrauded shareholders

A major corporate scandal of the last decade was resolved recently with the settlement of several lawsuits against the once high-flying drug company Valeant. A few years ago, Valeant was one of the glamour stocks of Wall Street. Its dynamic CEO Michael Pearson bragged that he just wanted to make money for shareholders. In the three years after Pearson took control, Valeant’s stock increased five-fold and Valeant showed an eight-fold jump in its revenue, from $1 billion in 2010 to $8 billion in 2014. 

But then news reports surfaced that Valeant had bought two drugs from a company called Marathon and hiked their prices more than 500 and 200 percent respectively.    On top of the price gouging, the CEO of a company that Valeant had acquired filed a whistleblower complaint laying out how Valeant was really a house of cards, pumping up its earnings with tax gimmicks and fraudulent accounting. 

It turned out that, among other wrongdoing, Valeant had been disguising the huge increases in its drug prices in its financial statements. In addition, much of the growth Valeant had been touting came from sales of its medications by a company called Philidor that Valeant had secretly set up to sell its drugs by mail and overcharge insurance companies.

When the truth came out, the price of Valeant’s shares plummeted. Suits against Valeant and some of its insiders by both the Securities and Exchange Commission (SEC) and its shareholders are just wrapping up. They provide an interesting insight into how the remedies achieved in securities frauds differ between government and private litigation. While the SEC can be effective in getting sanctions against fraudsters, the real financial benefit to investors comes from class actions brought on their behalf. 

The SEC settled with Valeant for a $45 million fine to be paid by the company and about $1 million in fines and other remedies against three of its top officials. By comparison, a class action led by the law firm Robbins Geller has been approved by a special master and, if given final court approval, will result in a recovery of more than $1.2 billion for Valeant shareholders — many more times than what the SEC obtained. And if approved by the court, 87 percent of the recovery in the private action will be distributed to Valeant shareholders. 

The wide disparity between SEC recoveries and those gotten in related private actions is nothing new. For instance, in the king of all securities frauds, Enron, the shareholder class action recovery was $7.2 billion in contrast to the SEC’s $450 million, a difference of 1,500 percent. 

Over its 85-year history, the SEC has generally enjoyed a good reputation as the “Cops of Wall Street,” policing dishonest practices in the sale and trading of securities and deterring corporate corruption. Yet the Valeant cases show how important private actions are for defrauded investors. Not only do the private actions provide substantial recoveries, but they also deter wrongdoing because, as one commentator put it, “Only a fraction of corporate executives who manipulate or misrepresent their companies’ performances get exposed by regulators for such misdeeds.”

It is for good reason then that the Supreme Court supports private actions, saying, “[T]he Court has long recognized that meritorious private actions to enforce federal antifraud securities laws are an essential supplement to criminal prosecutions and civil enforcement actions brought respectively by the Department of Justice and the Securities and Exchange Commission (SEC).”

As one observer colorfully put it, “Corporate Fraud is sort of like grass, it grows, it gets cut down, and it grows again.” Private suits are therefore essential. They provide a vehicle for defrauded stockholders to recover losses when they are cheated. In addition, the possibility that shareholders can bring a private action deters wrongful conduct and gives investors confidence that they will be treated fairly. As such, they are an important and integral adjunct to the SEC’s efforts to police the honesty and integrity of our capital markets.

Daniel J. Morrissey is a professor and former dean at Gonzaga University Law School.