3Com lawsuit a case study

Legal action taken against 3Com (COMS) this week could serve as a blueprint for shareholders seeking to sue companies over investments gone awry.

3Com matches the profile of most defendants named in securities fraud lawsuits: It is a high-tech company that allegedly forecast better-than-expected earnings wrongly, saw its executives sell off large numbers of shares, and then suffered a precipitous drop in its stock price.

Stanford law professor Michael Perino, who coauthored a study that outlined trends in securities fraud litigation since December 1995, said he couldn't comment directly on the 3Com case but noted that "certain salient characteristics are being searched for by plaintiff lawyers before the suit is brought."

Milberg Weiss Bershad Hynes & Lerach, the firm that filed the 3Com suit, refused to comment on any parallels between the 3Com suit and other high-profile securities cases. And Paul Bennett, a partner with Gold, Bennett & Cera, said the similarities are incidental.

"There are no cookie-cutter cases," said Bennett, a San Francisco-based law firm that handles shareholder lawsuits. "There are no laundry checklists."

Nevertheless, at least some similarities between the 3Com case and other securities lawsuits are clear.

First, 3Com is a leading high-tech firm. Technology companies are defendants in 33.9 percent of all securities fraud complaints, while finance companies, for example, make up only 10.1 percent.

Second, 3Com forecast better earnings than it produced. Milberg Weiss Bershad Hynes & Lerach, the high-profile law firm that filed the suit, contends that 3Com projected revenue and earnings growth ahead of analysts' estimates for the first and second quarters of fiscal 1997, and then forecast that its third and fourth quarters would increase sequentially and reach higher levels than previously projected. The stock rose from about 52 before late September to 81-3/8 in mid-December.

But on February 10, when 3Com announced that third-quarter revenues would fall short of the previous quarter and that earnings would be less than analysts' current estimates, the stock plunged to 37.

This is a frequent complaint in stockholder class actions. Misrepresentation in financial statements is the most common allegation against companies in securities fraud cases. Fifty percent of high-tech defendants in the last year have been charged with giving misleading financial statements, according to the Stanford study.

3Com is also right on target in the amount that its stock dropped. The company's shares declined 26 percent February 11, making it the biggest one-day fall in 3Com history. The Stanford study found that the average one-day drop for companies charged with securities fraud was about 31 percent.

The case against the networking giant also fits the typical profile since the plaintiff's have alleged insider trading. That charge, the suits says, is based on the fact that ten 3Com "insiders" sold 896,000 shares totaling about $59.3 million, right before rumors began circulating about impending competition from Intel-- and just before the stock began to fall.

3Com says that the allegations are without merit and intends to defend the lawsuit vigorously. "3Com management further believes that the company has always acted with integrity and in compliance with its legal disclosure obligations," the company said.

Allegations of insider trading strengthen plaintiff arguments, said Perino, whose study notes that such claims are on the rise in securities fraud cases. "This significant increase in alleged insider trading is consistent with the theory that plaintiffs are increasingly relying on trading by insiders to support the 'strong inference' pleading." Strong inference is a legal term that describes the amount of evidence necessary to create strong suspicion in a judge's mind that illegal dealings have taken place.

Insider trading charges are particularly prevalent in the technology industry. According to the study, 73.1 percent of complaints involving high-tech firms allege insider sales, compared with only 38.5 percent for all companies. The study acknowledges, however, that this is not surprising because stock options are commonplace for compensation in that industry.