Class actions asserting accounting irregularities fell sharply last year following a one-time increase in 2011 attributed to a surge of Chinese reverse mergers, according to a Cornerstone Research report. Even so, accounting fraud cases brought larger settlements than most shareholder litigation.
The consulting firm found that accounting fraud case filings dropped from 78 in 2011 to 45 in 2012—the fewest case filings in six years, reflecting an ebb tide for lawsuits against Chinese issuers that become public through reverse mergers with companies listed on U.S. stock exchanges. Many such deals resulted in financial restatements and alleged violations of generally accepted accounting principles. There were 21 fewer Chinese reverse merger cases in 2012 than during the year before.
"Reverse-merger cases themselves accounted for two-thirds of the drop we saw in accounting fraud cases," Cornerstone vice president Elaine Harwood said. "As those cases played out, one would assume that any of them that had a significant stock price reaction have been filed, and that trend is probably coming to an end."
Cornerstone first reported on the decline in case filings in March. The new report, issued on Wednesday, highlighted a subset of securities class action filings implicating the Sarbanes-Oxley Act, passed in 2002 in response to accounting scandals at WorldCom Inc. and Enron Corp. Accounting fraud cases, which Cornerstone has been tracking for the past four years, include alleged violations of generally accepted accounting principles, financial restatements or a failure to put into place sufficient internal controls.
Shareholder class actions slowed during the second half of the year, when only 14 accounting fraud cases were filed, representing 22 percent of total new class actions, according to Cornerstone. Accounting cases also made up a smaller proportion of total class action filings last year, decreasing to 30 percent from 42 percent in 2011.
For the third year in a row, most accounting fraud cases involved allegations or announcements of weaknesses in the internal controls required under Sarbanes-Oxley. And, for the second year in a row, more than one in three involved a financial restatement.
Such restatements were associated with an approximately 15 percent increase in the settlement amount, Harwood said. "The fact you’re having more cases involving restatements, or a greater proportion of them involving restatements, could lead to or continue the trend in accounting cases to represent a large portion of total settlement dollars."
Although the number of settlements was low, the proportion of accounting fraud cases that settled, when compared to overall securities class actions, increased in 2012 to 68 percent, compared to 49 percent the year before. Accounting fraud cases made up 90 percent of the $2.9 billion in settlement value in 2012, and the median settlement amount for an accounting fraud case was $15 million last year, compared to $6 million for an ordinary shareholder class action.
"We’re finding a striking difference between a typical settlement size for accounting cases compared to non-accounting cases," Harwood said. "That’s higher than in prior years."
Moreover, of the top six settlements worth $100 million or more in 2012, five involved accounting fraud allegations, she said.
"Even if filings were down, settlements are significant for accounting cases," Harwood said.
Cornerstone predicted that recent regulatory changes, including the Dodd-Frank Wall Street Reform and Consumer Protection Act, which encourages whistleblower participation in U.S. Securities and Exchange Commission cases, could increase the number of accounting fraud cases during 2013. The Jumpstart Our Business Startups Act, another reform passed last year, may increase the number of cases alleging internal control weaknesses, since it exempts emerging growth companies from having to publish an auditor report for as many as five years following an initial public offering.
"If you relax that requirement, and now you don’t have the added report on internal controls that might encourage companies to strengthen those controls, you could see emerging growth companies have restatements or issues with their accounting in the future that could lead to lawsuits," Harwood said.
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