The class actions against Molycorp may not be in its investors’ interest
Today, a seemingly new obstacle appeared on the path of recovery set out by Mr. Karayannopoulos. Bernstein Liebhard LLP (BL) announced that it has launched a class action lawsuit on behalf of Molycorp (NYSE: MCP) shareholders (who purchased securities between August 2, 2012 and August 7, 2013). According to the press release the lawsuit alleges that “throughout the Class Period, Defendants made false and/or misleading statements, as well as failed to disclose material adverse facts about the Company’s business, operations, and prospects”. The list of purported grievances includes Molycorp’s reporting of “inventory [that] was materially understated; overstated income tax benefit in the first quarter of 2013 by approximately $6.5 million; [lacking] adequate internal and financial controls; [leading to] materially false and misleading statements”. On August 8, during the Q2 results, Molycorp announced that “its unaudited Condensed Consolidated Financial Statements for the three months ended March 31, 2013 should no longer be relied upon because they contained an error with respect to the reconciliation of its physical inventory to the general ledger, which resulted in a cumulative overstatement of costs of sales and understatement of current inventory of approximately $16.0 million”.
Molycorp, the largest producer of rare earths outside China, changed leadership and direction last December when Constantine Karayannopoulos was appointed to take over as interim CEO. Previous CEO Mark Smith’s departure was not associated with an investigation from the Securities and Exchange Commission (SEC) on the veracity of the accounts of the company, said the chairman of Molycorp, Ross Bhappu. Molycorp insisted that the change of leadership was due to “a natural inflection point, demanding that it shift attention from development to operations.”
Get our daily investorintel update
Molycorp has invested heavily in the Project Phoenix side of its Mountain Pass mine in California and as announced during the Q2 results call, two weeks ago, Molycorp should be able to reach its target of about 20,000 tons per year of rare earth oxides. Nevertheless, as with most ambitious mining projects, development costs have soared. In early 2012, the estimated two phases of development cost was $ 718 million, reaching USD$ 1.25 billion by the end fueling group expenses ten-fold year to year (USD$ 1.31 billion at end of September 2012 against USD$ 169 in 2011). At the same time, Molycorp has been hard hit by the decline in the price of rare earths. In 2011, a kilogram of lanthanum oxide and cerium – the two main metals Molycorp produces – cost over $ 100. They have fallen to the USD$ 13-15 range. Constantine Karayannopoulos was entrusted to lead Molycorp through a difficult period, reducing costs and finding new sources of financing and credit.
Optimistic about the company’s future, Molycorp’s CEO still announced Q2 losses of USD$ 71.2 million or EPS adjusted earnings of USD$ -0.36/share, or worse than anayst predictions of USD$ -0.23/share. While BL launched the lawsuit today, the legal rumblings started the day after the Q2 results. Indeed, several other law firms have announced similar lawsuits against Molycorp; they include Pomerantz Grossman Hufford Dahlstrom & Gross LLP and Brown Piven – among others. In fact, Molycorp has already absorbed any share losses resulting from these announcements. MCP fell almost 10% – after a pre earnings rally – on August 9. Today, MCP closed at USD$ 6.01/share (+0.67%) on a day of very modest overall market gains. Rare earth prices, meanwhile, have continued to rise and the increases are a good sign. Another good sign is the potential for higher than expected sales of Tesla electric automobiles, which can only serve to boost demand for Molycorp products. Molycorp is still bullish about its rare earths demand forecast. This week has seen rising prices for such metals as praseodymium and neodymium. Last week, europium oxide, terbium and dysprosium all rose (after dropping a bit the previous week). The price of cerium oxide has remained stable as have the prices for lanthanum oxide, rare earth carbonate, samarium and yttrium.
If there is one aspect to consider when analyzing the Molycorps and other emerging and prospective rare earth plays it is that there are many difficulties in achieving profitable rare earths production. Nevertheless, this sector has strength, especially in the longer term, and there has been a steady bullish sentiment as even Molycorp, rose more than 40% since mid-June, triggered by reports of supply shortages in China. This is an important consideration because the lawsuits filed against Molycorp may not be in the interest of its shareholders. Legal experts have often criticized class actions citing the paradox that by suing their company, shareholders are actually suing themselves; in other words the lawsuit is detrimental to shareholders (even if it may prove ‘beneficial’ for the law firms). It would be more directly beneficial if a single shareholder were to act as the plaintiff against the Company, as one investor actually tried against Nokia, last year, citing the company’s failure to improve profits over a six-month period.
This highlights the other general problem, which is lawsuit frivolity. Law firms may be given to incite shareholders to sue on frivolous premises, because the firms will win regardless, given a propensity for these matters to be settled out of court. The shareholders typically receive very modest gains, more modest than if they simply allowed their company to improve operations and lift the stock in the market. Class action lawsuits are also an obstacle. They make managers nervous, afraid to take even well calculated risks that might result in gains for shareholders, fearing that their decisions might induce litigation. There is also another problem. Rules demanding companies be more forthright in their disclosure – a good thing certainly for all investors – have had the effect of increasing demand for even more disclosure (naturally this tends to happen when shareholders are upset about results). Companies are disclosing more and, ironically, being punished more because it gives plaintiffs, or class action lawsuit specialists, even more legal hooks to grab in order to reach litigation. .
Third, forward-looking disclosures must be impervious to lawsuits as long as they are accompanied by reasonable caveats. Fourth, in cases involving multiple defendants, damages must be attached proportionally to the blame that is attributed to a particular defendant. Finally, to reduce plaintiff lawyers’ ability to file frivolous lawsuits for their own gain, large shareholders must be allowed to petition the court to be appointed as lead plaintiff. In the case of Molycorp, the overly optimistic ‘attitude’ of former CEO Mark Smith led to an SEC investigation into the company’s disclosure practices. That is essentially what the spate of class actions is about. However, observers and shareholders should be alerted to the potential for frivolity given that the SEC itself, last June 27, announced that it “does not recommend any enforcement action”. Surely, Molycorp should account for its mistakes, but if the SEC itself has failed to note wrongdoing after a nearly one year long investigation, it seems unlikely that the class actions will, should they ever reach the Courts.